Expansionary fiscal policy examples and charts - Jotscroll (2023)

During a recession, if the government uses expansionary fiscal policy to increaseGDP, economic growth will accelerate. also the aggregatedemand curveit will move to the right. This is because, during this period, the economy operates below the full employment level and economic growth is slow. According to monetarists, an expansionary fiscal policy aims to increase the money supply in an economy.

The government employs expansionary fiscal policy when the economy is below full employment to reduce the unemployment rate and increase economic activities. Therefore, if an economy is in recession, expansionary fiscal policy will increase aggregate demand, stimulatingeconomic growth.

Expansionary fiscal policy is less effective in an open economy because an increase in government spending can cause interest rates to rise, thus raising the value of the currency, which in turn crowds out net exports. The crowding-out effect of expansionary fiscal policy suggests that an increase in government spending from borrowing will lead to an increase in the interest rate which, in turn, will reduce investment. In essence, the act of increasing the public sector tends to reduce or even eliminate private sector spending. Therefore, an expansionary fiscal policy leads to an economic boom.

Aggregate demand and consumer spending are two important factors that stimulate the growth of an economy. Cutting corporate tax makes more money available to companies. In turn, the government hopes that this money will be applied to new investments, thus increasing employment. This implies that tax cuts help create more jobs. However, if the company already has enough cash, it can use the tax cuts as a means to buy back shares or buy new companies. Supply-side economic theory recommends that the government cut corporate taxes instead of income taxes and also strive to cut capital gains taxes to cause an increase in business investment. However, the Laffer Curve points out that this form of trickle-down economics is only effective if tax rates are already 50% or higher.

According to Keynesian economic theory, expansionary fiscal policy, like expansionary monetary policy, is one of the most effective tools available to the government to promote economic activity during a period of recession. As stated above, during a recession, there is a drop in aggregate demand and businesses and consumers also reduce their spending. This also implies a fall in aggregate demand that can create a vicious circle if the government does not control it. This is a situation where weak consumer demand leads to lower investment by businesses, which leads to further depressed demand. The government needs to counter this cycle. Expansive fiscal policy is very critical for this action. The expansionary tools of fiscal policy are tax cuts and increases in public spending.

The government uses this as a mechanism to push economic growth to a healthy level, as it is needed for the downturn phase of the business cycle. However, an expansionary fiscal policy can result in inflation.

Examples of expansionary fiscal policy

The following are some examples of expansionary fiscal policy in action;

1. An example of expansionary fiscal policy would be government spending on building bridges or roads to create more jobs and increase the income of the population.
2. In the government of Donald Trump, the expansive fiscal policy was implemented with tax cuts and the Employment Law. There was also an increase in discretionary spending, mainly for national defense.
3. In the Obama administration, the government used expansionary fiscal policy with the Economic Stimulus Act, the American Recovery and Reinvestment Act, lowering the tax rate, and extending employee benefits. They also financed public works projects, as well as other public expenditures. The law enacted in 2009 was intended to stimulate economic activities and growth as the economy was losing steam. The cost of tax cuts and public spending was $787 billion, which occurred while tax collections were declining.
4. The George Bush administration used expansionary fiscal policy to end the economic recession in 2001 by lowering income taxes with the Tax Relief and Economic Growth Reconciliation Act, which accelerated the reduction of tax payments. It was unfortunate that the terrorist attacks that took place caused the recurrence of an economic crisis. Bush launched the War on Terror and cut business taxes in 2003 with the Jobs and Growth Tax Relief Reconciliation Act. Starting in 2004, the economy returned to good shape, and unemployment fell to 5.4 percent.
5. President John F. Kennedy's administration used expansionary fiscal policy to lift the economy out of the recession of the 1960s. It pledged to maintain the policy until the recession ended, regardless of the impact on debt.
6. To end the Great Depression, President Franklin D. Roosevelt used an expansionist policy. Initially, this policy worked, but he later made a reduction in New Deal spending to balance the budget. Consequently, this led to a recurrence of the Depression in 1932. However, Roosevelt brought back expansionary fiscal policy to help prepare for World War II.

Other examples of expansionary fiscal policy include building roads, schools, factories, and lowering income taxes to increase purchasing power and eliminate slump in demand.

It is important to note that private investment is not excluded in this case, since expansionary fiscal policy may take the form of an increase in the investment component of government purchases and spending. The government buys goods such as office supplies and services. However, the government can also buy investment items such as roads and schools. It is in this case that there may be a displacement of private investment by public investment.

The opposite of displacement occurs in thecontractionary fiscal policywhere there is a cut in government purchases (or transfers), tax increases, or both. Such measures lead to a reduction in the deficit and an increase in the surplus. This would reduce government borrowing and shift the bond supply curve to the left.

It is clear that exclusion weakens the impact of fiscal policy. Thus, crowding out occurs when expansionary fiscal policy leads to higher public spending by the government. However, effective expansion will generate healthy economic growth.

Expansionary Fiscal Policy Chart

An expansionary fiscal policy is best represented by a graph; You will see from the graph below that the original equilibrium E_ois a representation of an economic recession occurring at a quantity of output Yr that is below potential GDP. However, a change in the aggregate demand for AD₁sapo₂that arose through an expansionary fiscal policy can lead the economy to a new equilibrium of production, that is, of E₁Toe₂at the level of potential GDP. As a result of the economy's output below potential GDP, an inflationary increase in the price level of P₁principal₂the results will be relatively small.

Advantages of expansionary fiscal policy

1. The objective of expansionary fiscal policy is to increase productivity
2. Expansionary fiscal policy is used to boost economic growth
3. increase in employment
4. Another objective of expansionary fiscal policy is to restore consumer and business confidence.
5. increased productivity

Since this type of fiscal policy aims to increase the money supply, productivity increases accordingly. The demand for goods and services increases and this makes companies prepare to increase their production in quantity and quality.

Drives economic growth

This fiscal policy helps boost the growth of a nation's economy, especially in the recession phase. This makes it necessary to adopt an expansionary policy during the low growth phase. With this, there is a reduction in the restrictions for loan applications, as well as in interest rates. This in turn causes an increase in the flow of capital into the economy.

increase in employment

When there is an increase in profit and income, there will be a corresponding increase in the demand for labor. As it becomes easier to borrow, it becomes profitable for businesses to hire new employees, which reduces unemployment.

Restores consumer and business confidence.

Consumer and business confidence is a vital factor in the continued growth of an economy and this is restored by expansionary fiscal policy. This is because they have in mind that the government will take the necessary measures to end the recession, as this is essential for them to start spending again. If trust is lacking, everyone will keep their money without spending or investing.

Disadvantages of expansionary fiscal policy

1. Increase in public spending
2. The absence of price stability in different products.
3. excess money supply

Increase in public spending

This fiscal policy tends to increase public spending and this leads to a reduction in taxes. When there is a tax cut, the economy will run a budget deficit. In turn, there will be a high debt ratio and an increase in public debt.

The absence of price stability in different products.

In several products there is a lack of price stability. This is because the increase in the money supply makes it less important when it comes to related products. In addition, higher costs are established for goods of limited quantity.

excess money supply

If the economy is at full employment, expansionary fiscal policy is more likely to lead to inflation. Inflation means an excess supply of money in the economy that seeks few goods, which causes a persistent increase in prices. An increase in inflation brings unnecessary problems in an economy. Therefore, it is critical that the government be very careful when employing this economy. It should not only focus on economic growth, but also on stability.

Ricardian equivalence theory and expansionary fiscal policy

Ricardian equivalence theory holds that expansionary fiscal policy will be ineffective because investors and consumers will understand that governments will have to pay debts in the form of future taxes. It is an economic theory that states that the act of financing public spending with current or future taxes, as well as current deficits, will have equivalent effects throughout the economy. This theory also argues that people will save based on how they expect the government to charge higher future taxes to pay off the debt, and this will offset the increase in aggregate demand from increased government spending. By implication, Keynesian fiscal policy will not be effective in boosting economic output and overall growth.

This theory was proposed by David Ricardo in the early 19th century and elaborated by Professor Robert Barro (Harvard professor). It is for this reason that Ricardian equivalence is also known as the Barro-Ricardo equivalence proposition.

In essence, this theory proposes that public deficit spending is equivalent to current fiscal spending. Because taxpayers save more to pay expected future taxes, this tends to offset the macroeconomic effects of increased government spending.

How expansionary fiscal policy affects the GDP of an economy

Expansive fiscal policy can impact the gross domestic product (GDP) of an economy through the fiscal multiplier. The fiscal multiplier should not be confused with the monetary multiplier. It is the relationship between a change in national income and the change in government spending that caused the change. When this multiplier is greater than one (1), the greater effect it will have on national income is called the multiplier effect.

The multiplier effect occurs when an increase in the amount of government spending causes an increase in income and consumption, which further increases income. If income increases further, consumption will also increase and the cycle will continue. This will cause an overall increase in national income greater than the initial increase in spending. In other words, when there is an initial change in aggregate demand, there will also be a change in aggregate output, as well as the aggregate income it generates, which becomes a multiple of the initial change. Economists have used the multiplier effect as an argument for the effectiveness of public spending or tax cuts in stimulating aggregate demand in the economy.

For example, if the government of an economy decides to spend $1 million to build a power plant, this does not mean that the money will simply disappear. Some of that money will be turned into wages for builders and some into revenue for vendors, etc. As a result, builders will have more disposable income, which will lead to increased consumption. In this case, the aggregate demand will certainly increase. In addition, if the recipients of new expenses of the builders increase the demand more and consumption increases, the production of the recipients of the rents of the builders will also increase. The increase in GDP will then be the sum of the increases in the net income of all those affected.

Expansive fiscal policy versus contractive fiscal policy

In general, expansionary fiscal policy is the opposite of contractionary fiscal policy.

By definition, expansionary fiscal policy refers to the policy adopted by the government aimed at promoting consumption in the economy that aims to expand the economy. On the other hand, a contractionary fiscal policy is a fiscal policy that the government adopts to contract the economy.

These fiscal policies have an impact on the aggregate demand of an economy, but these impacts differ. While expansionary fiscal policy increases aggregate demand, with contractionary fiscal policy the opposite occurs, that is, it translates into a reduction in aggregate demand in an economy.

When the government adopts an expansionary fiscal policy, consumption increases. On the other hand, consumption decreases when the government adopts a contractionary fiscal policy.

In addition, expansionary policy leads to an increase in the purchasing power of individuals and companies, while contractionary fiscal policy leads to a decrease in purchasing power.

The fact is that the government uses expansionary fiscal policy to boost the economy, which can result in inflation if left unchecked. On the other hand, the government uses a contractionary fiscal policy to keep inflation under control.

Expansive fiscal policy leads to an increase in the fiscal deficit. On the other hand, a contractionary fiscal policy leads to a decrease in the fiscal deficit.

Frequently asked questions about expansionary fiscal policy