Fiscal policy and aggregate demand
Fiscal policy and aggregate demand: build the core model, apply it to evidence and qualify conclusions where outcomes depend on context.
9708 section 5.2; AS Level. Checked against Cambridge's 2026–2028 Version 2 (latest version published December 2025) and 2029 Version 1 (published September 2026). Cambridge states that neither version has significant changes affecting teaching. Always follow the syllabus for the candidate's examination year.
Before you begin
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
How does a government budget deficit differ from national debt?
What you will learn
- Define budgets, deficits, surpluses and national debt
- Classify taxes and marginal and average rates
- Distinguish current from capital spending
- Analyse expansionary and contractionary fiscal policy with AD/AS
Core model and terms
A government budget records planned revenue and spending for a period. A deficit occurs when spending exceeds revenue in that period; a surplus is the reverse. National debt is the accumulated stock of public borrowing, so it is not the same as one year’s deficit. Direct taxes are paid on income or wealth; indirect taxes are levied on spending. Progressive, proportional and regressive describe how the tax burden changes relative to income.
Apply and evaluate
Current spending funds ongoing services; capital spending creates or improves assets. Expansionary fiscal policy can raise AD through higher government spending or lower taxes; contractionary policy can lower AD. Use AD/AS to trace real output, price level and employment, then qualify the result by capacity, financing, imports and the composition and timing of measures.
Pause and explain
Which statement best applies fiscal policy and aggregate demand?
Worked example
A worker earns $40,000 and pays $6,000 tax. After a pay rise to $44,000, tax is $7,480. Calculate the average and marginal tax rates across the change.
Show the worked solution
- Average rate = 7,480 ÷ 44,000 × 100 = 17%
- Marginal rate = 1,480 ÷ 4,000 × 100 = 37%
- The two rates answer different questions
Answer Average rate = 7,480 ÷ 44,000 × 100 = 17% → Marginal rate = 1,480 ÷ 4,000 × 100 = 37% → The two rates answer different questions
Try a topic test
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Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
A worker earns $40,000 and pays $6,000 tax. After a pay rise to $44,000, tax is $7,480. Calculate the average and marginal tax rates across the change.
Give me a hint
Average rate is total tax divided by income; marginal rate compares the tax change with the income change.
Compare my reasoning
- Average rate = 7,480 ÷ 44,000 × 100 = 17%
- Marginal rate = 1,480 ÷ 4,000 × 100 = 37%
- The two rates answer different questions
Average rate = 7,480 ÷ 44,000 × 100 = 17% Marginal rate = 1,480 ÷ 4,000 × 100 = 37% The two rates answer different questions
Look for these in your work
- Average rate = 7,480 ÷ 44,000 × 100 = 17%
- Marginal rate = 1,480 ÷ 4,000 × 100 = 37%
- The two rates answer different questions
A government’s annual spending is $510bn and revenue is $480bn. Calculate the budget balance and identify its sign.
Give me a hint
Subtract revenue from spending using a stated sign convention.
Compare my reasoning
- Spending exceeds revenue by $30bn
- Balance = revenue − spending = −$30bn
- The government has a $30bn deficit
Spending exceeds revenue by $30bn Balance = revenue − spending = −$30bn The government has a $30bn deficit
Look for these in your work
- Spending exceeds revenue by $30bn
- Balance = revenue − spending = −$30bn
- The government has a $30bn deficit
The government builds a flood barrier and increases teacher salaries. Classify the two spending types and explain.
Give me a hint
Distinguish investment in an asset from recurring service costs.
Compare my reasoning
- The barrier creates a durable public asset
- It is capital spending
- Salaries fund an ongoing service and are current spending
The barrier creates a durable public asset It is capital spending Salaries fund an ongoing service and are current spending
Look for these in your work
- The barrier creates a durable public asset
- It is capital spending
- Salaries fund an ongoing service and are current spending
The economy has substantial spare capacity. The government raises infrastructure spending. Trace a likely short-run effect and one qualification.
Give me a hint
Start from G in AD, then consider capacity and implementation timing.
Compare my reasoning
- Higher G shifts AD right
- With spare capacity, real output and employment may rise
- The effect depends on project timing, imports, financing and available labour
Higher G shifts AD right With spare capacity, real output and employment may rise The effect depends on project timing, imports, financing and available labour
Look for these in your work
- Higher G shifts AD right
- With spare capacity, real output and employment may rise
- The effect depends on project timing, imports, financing and available labour
Common mistakes
- Calling the annual deficit the national debt, or claiming expansionary fiscal policy must raise real output by a fixed amount.
What can you explain now?
How does a government budget deficit differ from national debt?
Compare with the explanation
A deficit is a flow over a period; national debt is a stock of accumulated borrowing
The deficit is an annual budget gap, while debt records outstanding liabilities at a date.
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Make it stick
Before moving on, explain the central idea in fiscal policy and aggregate demand and state one condition that could change its effect.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.