AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/3/3-8)
Unit 3 · Topic 3.8
3.8 Fiscal Policy
Fiscal policy is the government's use of spending, taxes and transfer payments to influence aggregate demand. Expansionary policy aims to close a recessionary gap and contractionary policy aims to close an inflationary gap. Government spending changes AD directly and by more than an equal change in taxes, and real-world policy faces time lags.
Key terms
- expansionary fiscal policy
- contractionary fiscal policy
- government spending
- transfer payments
- discretionary fiscal policy
- time lags
Tools and goals
Governments use fiscal policy to pursue goals like full employment and stable prices. Its tools are government purchases of goods and services (G), taxes (T) and transfer payments (money paid to people without a good or service in return, like unemployment benefits).
Discretionary fiscal policy is a deliberate decision, such as a new law raising spending or cutting taxes. Automatic stabilizers, covered in 3.9, change without any new law.
Expansionary vs. contractionary
Expansionary policy fits a recessionary (negative) gap: it shifts AD right toward the point where AD meets SRAS on LRAS. Contractionary policy fits an inflationary (positive) gap: it shifts AD left to bring output back to YF and ease price pressure.
On the graph, show AD1 shifting to AD2, the new equilibrium at a higher (or lower) PL2 and Y2, and LRAS at YF so the reader can see the gap closing.
| Policy | Actions | AD | Short-run price level | Short-run real GDP | Short-run unemployment |
|---|---|---|---|---|---|
| Expansionary | Raise G, cut taxes, raise transfers | Shifts right | Rises | Rises | Falls |
| Contractionary | Cut G, raise taxes, cut transfers | Shifts left | Falls | Falls | Rises |
Direct vs. indirect effects
A change in government spending adds to AD directly: every dollar of G is spending. A change in taxes or transfers works indirectly: it changes disposable income first, and households spend only part of the change (the MPC) and save the rest.
That's why the government spending multiplier (1 ÷ MPS) is larger than the tax multiplier (MPC ÷ MPS in size). To close a given gap, the government needs a smaller change in spending than in taxes (3.2).
Time lags
Because of lags, a policy can arrive after the economy has already started to recover, adding fuel when less is needed. Economists also debate how big multipliers are in practice, how fast the economy self-corrects, and how much deficits matter later (Unit 5). These are real disagreements, and the exam won't ask you to pick a side; it asks you to explain how each policy shifts AD and what that does to output, prices and unemployment.
- Recognition lag: it takes time to collect data and realize a recession or inflation has started.
- Decision (legislative) lag: lawmakers have to debate, agree on and pass a policy.
- Implementation and impact lag: once passed, it takes time to spend the money or change tax collections, and more time for the multiplier rounds to play out.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Choosing and sizing a policy
An economy is producing $300 billion below full-employment output. The MPC is 0.75. (a) Name the type of fiscal policy needed. (b) What change in government spending would close the gap? (c) What change in taxes would close it instead? (d) What happens to the price level and unemployment?
Show the solutionHide the solution
- Step 1: (a) Output below YF is a recessionary gap, so the government needs expansionary fiscal policy.
- Step 2: (b) Spending multiplier = 1 ÷ (1 − 0.75) = 4. Required increase in G = $300 billion ÷ 4 = $75 billion.
- Step 3: (c) Tax multiplier = −0.75 ÷ 0.25 = −3. Required change in taxes = −$300 billion ÷ 3 = −$100 billion, a tax cut of $100 billion.
- Step 4: (d) AD shifts right. In the short run, the price level rises and real GDP rises toward YF, so unemployment falls toward the natural rate.
Answer: (a) Expansionary. (b) Increase G by $75 billion. (c) Cut taxes by $100 billion. (d) The price level rises and unemployment falls.
- Example 2
Matching the policy to the gap (classic trap)
Real GDP is above full-employment output and the price level is rising quickly. A student recommends cutting taxes "to help households deal with higher prices." Is that the correct fiscal policy to close the gap?
Show the solutionHide the solution
- Step 1: Output above YF is an inflationary gap, so the policy to close it is contractionary: shift AD left.
- Step 2: A tax cut raises disposable income, so consumption and AD rise. That widens the inflationary gap and pushes the price level up further.
- Step 3: The policies that close this gap are a decrease in government spending, an increase in taxes, or a decrease in transfer payments.
Answer: No. A tax cut is expansionary and would worsen the inflationary gap. Contractionary policy (lower G, higher taxes or lower transfers) shifts AD left and closes it.
Common mistakes
- Listing every possible policy. When a question asks for one fiscal policy action, give one specific action that fits the gap.
- Mixing up fiscal and monetary policy. Fiscal policy is spending and taxes by the government; changing the money supply or interest rates is monetary policy by the central bank (4.6).
- Using the spending multiplier for a tax change, or thinking an equal tax cut and spending increase have the same effect.
- Showing fiscal policy as a shift in SRAS or LRAS. In this model, fiscal policy shifts AD.
On the exam
- Long free-response questions often go: identify the gap, name an appropriate fiscal policy action, show it on the AD–AS graph, then calculate the required change with the multiplier. Practice the whole chain.
- Be specific. "Increase government spending" earns a point; "use fiscal policy" doesn't.
Connected topics
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Check yourself
4 questions on 3.8 Fiscal Policy. Pick an answer to see if you got it, and why.
An economy is in a recessionary gap. Which of the following fiscal policy actions would be appropriate to move it toward full employment, and what would be its short-run effect on the price level?
Which combination of fiscal policies would be most likely to close an inflationary output gap?
Which of the following best illustrates a time lag in discretionary fiscal policy?
Which of the following is an example of fiscal policy?
0 of 4 answered