Fiscal Policy: formula sheet

Key formulas

Government budget balance

Balance = Tax revenue − Government spending

Positive means surplus, negative means deficit. Spending here includes transfers and interest.

Expansionary fiscal stance

Higher spending and/or lower taxes → higher aggregate demand

Used to fight recession. Usually widens the deficit.

Contractionary fiscal stance

Lower spending and/or higher taxes → lower aggregate demand

Used to cool an overheating economy or reduce inflation pressure.

Tool classification

Spending: transfers, current, capital. Revenue: direct (income, wealth), indirect (VAT, excise, tariffs)

Most exam items test which bucket a given measure falls in.

Budget balance

Budget balance = Government revenue (taxes) − Government spending

Negative means a deficit, positive means a surplus.

Aggregate demand components

AD = C + I + G + (X − M)

Fiscal policy acts directly on G and, through taxes and transfers, on C and I.

Expansionary stance

Higher G and/or lower taxes → AD shifts right

Typical effect: higher output and employment, upward pressure on prices, larger deficit.

Contractionary stance

Lower G and/or higher taxes → AD shifts left

Typical effect: lower output and inflation pressure, smaller deficit.

Budget balance

Deficit = Government spending − Tax revenue

A positive result is a deficit. Spending includes interest on existing debt.

Primary balance

Primary balance = Revenue − (Spending excluding interest)

Shows the budget position before the cost of past debt.

Debt-to-GDP ratio

Debt ratio = Public debt ÷ GDP

Main measure of debt burden. Use nominal values for both.

Debt ratio stability condition

Ratio rises if (r − g) × (D/Y) + (primary deficit/Y) > 0

r = interest rate on debt, g = nominal GDP growth, D/Y = debt-to-GDP. Ratio is stable when this sum equals zero, and falls when it is negative. This is a first-order approximation.

Rule of thumb

If g > r, a country can run a primary deficit of up to (g − r) × D/Y and keep the ratio stable

A larger primary deficit still raises the ratio. If r > g, a primary surplus is needed to hold the ratio steady when debt is positive.

Total lag of discretionary policy

Total delay = recognition lag + action lag + impact lag

Recognition and action lags are decision delays. Impact lag is the delay before the policy takes effect in the economy.

Automatic stabilizer rule

Income falls → tax receipts fall and transfers rise; income rises → tax receipts rise and transfers fall

Needs no new legislation, so there is no action lag. Stabilizers reduce, but do not eliminate, cyclical swings.

Budget balance

Budget deficit = government spending − tax revenue

Stabilizers widen the deficit in a recession without any policy decision.

Easy money, easy fiscal

Output ↑ ; interest rates ↕ (unclear) ; public sector ↑ ; private sector ↑

Both boost aggregate demand. Output is higher. The effect on rates is mixed: monetary lowers them, fiscal borrowing raises them.

Tight money, tight fiscal

Output ↓ ; interest rates ↕ (unclear) ; public sector ↓ ; private sector ↓

Both reduce aggregate demand. Output is lower. The effect on rates is mixed: tight money raises them, but reduced government borrowing lowers them.

Tight money, easy fiscal

Output ↕ (unclear) ; interest rates ↑↑ ; public sector ↑ ; private sector ↓

Government spends more and borrows. Tight money and heavy borrowing both raise rates. High rates crowd out private investment.

Easy money, tight fiscal

Output ↕ (unclear) ; interest rates ↓↓ ; public sector ↓ ; private sector ↑

Easy money and less government borrowing both lower rates. Low rates and a smaller deficit leave room for private investment.

Aggregate demand link

Easy policy → AD ↑ ; Tight policy → AD ↓

Use this to decide output when both policies point the same way.

Quick revision

• Fiscal policy uses government spending and taxation; monetary policy uses interest rates and money supply.
• Expansionary policy: higher spending or lower taxes, which raises demand and usually widens the deficit.
• Contractionary policy: lower spending or higher taxes, which reduces demand and usually narrows the deficit.
• Spending multiplier = 1 ÷ [1 − MPC × (1 − t)].
• With a tax rate above zero, the multiplier is smaller than 1 ÷ (1 − MPC).
• Government spending changes usually have a larger multiplier than equal tax changes, because some of a tax cut is saved.
• Ricardian equivalence: people save today to pay expected future taxes, which offsets the deficit's stimulus.
• Crowding out: government borrowing pushes up interest rates and reduces private investment.
• Implementation lags: recognition, action and impact lags can make policy arrive late.
• A deficit adds to public debt; debt is usually compared with GDP.
• Automatic stabilizers, such as progressive taxes and unemployment benefits, work without new decisions.
• Fiscal and monetary policy can reinforce or offset each other, so always check both settings.

Common mistakes

• Treating transfer payments as government purchases of goods and services. Fix: Transfers move income without buying output. They are spending in the budget but not part of government purchases in GDP.
• Calling VAT or sales tax a direct tax. Fix: Direct taxes hit income or wealth. Taxes on goods and services are indirect, even if firms remit them.
• Treating a tax increase as expansionary. Fix: Think of the private sector: higher taxes reduce disposable income, so demand falls. Tax increase is contractionary.
• Assuming a larger deficit always means expansionary policy. Fix: Separate the automatic cyclical change from discretionary action. Judge the stance by deliberate changes in spending and tax rates.
• Treating the deficit and the debt as the same thing. Fix: Remember deficit is a yearly flow and debt is the accumulated stock. Deficits add to debt.
• Saying crowding out always happens. Fix: Link it to the economy's state. It is strongest near full capacity and weaker with idle resources.
• Saying automatic stabilizers have an action lag. Fix: Stabilizers are built into existing law, so no new decision is needed. They have essentially no action lag.
• Mixing up action lag and impact lag. Fix: Action lag ends when the measure is enacted. Impact lag starts after that and ends when the economy responds.
• Stating a definite output effect when the policies conflict Fix: For tight money with easy fiscal, or easy money with tight fiscal, output is uncertain. Look for that wording.
• Saying interest rates fall when both policies are easy Fix: With both easy, the rate effect is unclear. Monetary pushes rates down, fiscal borrowing pushes them up.

Exam tips

• Questions are usually classification or direction items. Name the tool first, then the effect.
• Check the economic condition before the policy: the same tool is expansionary or contractionary depending on direction.
• Watch for words like transfer, capital, direct and indirect. Each one points to a precise definition.
• Remember automatic stabilisers need no new decision. That detail often separates two options.
• With no penalty for wrong answers, always answer. Eliminate options that move demand the wrong way first.
• Questions are usually direction questions. Decide expansionary or contractionary first, then read the options.
• Watch for cases where a deficit rises because of a recession. The stem will say whether the change is discretionary or automatic.
• When spending and taxes move in opposite directions, check which change is larger or whether the stem states the net effect.