- What is an expansionary fiscal policy?
- What does expansionary fiscal policy do?
- What is the objective of expansionary fiscal policy?
- Examples of expansionary fiscal policy
- How does expansionary fiscal policy affect interest rates?
- Expansionary Fiscal Policy Chart
- Advantages of expansionary fiscal policy
- Drives economic growth
- increase in employment
- Restores consumer and business confidence.
- Disadvantages of expansionary fiscal policy
- Increase in public spending
- The absence of price stability in different products.
- excess money supply
- Ricardian equivalence theory and expansionary fiscal policy
- How expansionary fiscal policy affects the GDP of an economy
- Expansive fiscal policy versus contractive fiscal policy
- Frequently asked questions about expansionary fiscal policy
- What is the main objective of expansionary fiscal policy?
- What does expansionary fiscal policy affect?
- Why is an expansionary fiscal policy used?
- What is the most expansive fiscal policy?
- What is an example of expansionary fiscal policy?
What is an expansionary fiscal policy?
an expansionisttax policyreceives this name because it is the government action that implies the expansionmoneysupply with the use of budgeting tools to increasegovernmentspend or cuttaxes. Both actions make more money available to consumers to spend. Therefore, an expansionary fiscal policy implies increasing government spending or reducing taxes, or a combination of both, to increase aggregate demand.
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.
What does expansionary fiscal policy do?
It is important to understand that the government follows an expansionary fiscal policy if it perceives that the economy is contracting. For government spending, such as the use of subsidies, social welfare, education,transport, and tax cuts, expansionary fiscal policy will lead to higher consumption and investment. This is because more disposable income is left in the hands of consumers and investors.
Also,unemployment ratedecreases as an increase in consumption causes an increase in aggregate demand. In turn, there will be a need for industries to hire more workers who, in turn, will have more money to spend and invest. Therefore, an expansionary fiscal policy stimulates economic activity and growth.
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.
What is the objective of expansionary fiscal policy?
The objective of an expansionary fiscal policy is to accelerate economic growth by increasing aggregate demand through economic stimuli. By implication, an increase in government spending and a reduction in taxes increase the money supply in the economy, thus increasing the level of consumption in the economy. Therefore, this government activity increases economic activity, triggering an economic boom.
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;
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
How does expansionary fiscal policy affect interest rates?
As has been emphatically stated, the objective of an expansive fiscal policy is to increase the economy's aggregate demand, that is, by increasing public spending and reducing taxes.
Expansive fiscal policy can lead to higher interest rates. If that happens, it will discourage businesses and households from borrowing and spending, which in turn will reduce aggregate demand. Even if the lower aggregate demand resulting from higher interest rates does not offset the direct effect of expansionary fiscal policy, the power of fiscal policy may turn out to be less than initially expected. This refers to avoidance in which government spending and borrowing causes interest rates to rise, thereby reducing household consumption and business investment.
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 Eois 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
- The objective of expansionary fiscal policy is to increase productivity
- Expansionary fiscal policy is used to boost economic growth
- increase in employment
- Another objective of expansionary fiscal policy is to restore consumer and business confidence.
- 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
- Increase in public spending
- The absence of price stability in different products.
- 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
What is the main objective of expansionary fiscal policy?
The main objective of expansionary fiscal policy is to get the economy out of recession and prevent economic depression. In essence, the objective is to increase aggregate demand and stimulate economic growth.
What does expansionary fiscal policy affect?
Expansive fiscal policy affects personal income levels, aggregate demand, business production, consumption, investment, and employment. This is because tax cuts leave people with more disposable income, which in turn increases their demands.
On the part of companies and industries, they are being pressured to produce more. This requires the need to employ more workers, thus reducing unemployment. In addition, government spending on basic services, education, and welfare also provides more opportunities and income for individuals and businesses. The higher the income, the higher the consumption and investment.
Why is an expansionary fiscal policy used?
The government uses expansionary fiscal policy to increase aggregate demand in the economy. It is a tool that helps contain the economic recession and prevent the economy from reaching the depression stage. When the government stimulates economic activities using this economic tool, the economy will grow. In that case, through tax cuts and increased government spending, there will be a decrease in unemployment.
Employment opportunities arise as a result of an increase in aggregate demand. There is more money in the hands of companies and individuals to invest and spend, which causes an increase in aggregate demand. When aggregate demand increases, there will be a need for industries to produce more, which will also require employing more workers. So spending goes up, aggregate demand goes up, production goes up, and the cycle continues. In essence, the more workers that are employed, the more disposable income there will be.
What is the most expansive fiscal policy?
Expansive fiscal policy implies tax cuts and increased government spending.
What is an example of expansionary fiscal policy?
An example of expansionary fiscal policy would be for the government to cut income taxes and spending on projects like building roads, schools, bridges, and factories to promote economic activity.
- What is the unemployment rate? Calculation and Formula
- Balance of payments; What is BOP?
- Causes and effects of deflation in the economy
- What is Financial Management? Function, principles and types.
What are some examples of expansionary fiscal policy? ›
The two major examples of expansionary fiscal policy are tax cuts and increased government spending. Both of these policies are intended to increase aggregate demand while contributing to deficits or drawing down budget surpluses.What is expansionary fiscal policy graph? ›
Expansionary Fiscal Policy Graph
Fiscal policy causes demand (D) to rise, leading to prices rising, resulting in GDP growth. The S curve depicts aggregate supply. The implementation of fiscal policies triggers a spike in demand, leading to price increases and GDP growth.
A contractionary policy is a tool used to reduce government spending or the rate of monetary expansion by a central bank to combat rising inflation. The main contractionary policies employed by the United States include raising interest rates, increasing bank reserve requirements, and selling government securities.What are the three expansionary fiscal policies? ›
Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers.What is expansionary fiscal policy and when is it used? ›
When the government's budget is running a deficit (when spending exceeds revenues), fiscal policy is said to be expansionary. When it is running a surplus (when revenues exceed spending), fiscal policy is said to be contractionary. decreasing economic activity, known as recessions.Which curve is affected by fiscal policy? ›
Policymakers can influence aggregate demand with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left.What was Trump's fiscal policy? ›
Over his term, Trump reduced federal taxes and increased federal spending, both of which significantly increased federal budget deficits and the National Debt.What is a Keynesian graph? ›
Key points. The expenditure-output model, or Keynesian cross diagram, shows how the level of aggregate expenditure varies with the level of economic output.Which is an example of expansionary fiscal policy quizlet? ›
An example of expansionary fiscal policy would be . . . cutting taxes.What is a real life example of contractionary fiscal policy? ›
An example of contractionary fiscal policy could be when the government decides to decrease government spending. Meaning, that government programs, like the forest service, healthcare benefits, or the military, will receive less funding.
What is a real life example of contractionary monetary policy? ›
The government deposits U.S. Treasury notes at the Fed like you deposit cash. To implement a contractionary policy, the Fed sells these Treasurys to its member banks. The bank must pay the Fed for the Treasurys, reducing the credit on its books. As a result, banks have less money available to lend.Are stimulus checks an example of expansionary fiscal policy? ›
In a recession, a government can act through expansionary fiscal policy, where it increases government spending and decreases taxes to stimulate the economy. A stimulus check can be considered a form of decreasing taxes in order to boost consumption.What are the four 4 major functions of fiscal policy? ›
There are lots of fiscal policy objectives, but the main ones are allocating resources, short-term stabilization, longer-term development and maximizing employment.Who uses expansionary fiscal policy? ›
The Obama administration used expansionary policy with the Economic Stimulus Act. 9 The American Recovery and Reinvestment Act cut taxes, extended unemployment benefits, and funded public works projects.What is an example of expansionary monetary policy *? ›
What action is an example What action is an example of an expansionary monetary policy a lowering the interest unreserved rates he's selling Treasury securities, see raising the discount right, raising the reserve requirement. The correct answer is a lowering the interest rate on reserves.How does expansionary fiscal policy affect unemployment? ›
The goal of expansionary fiscal policy is to reduce unemployment. Therefore the tools would be an increase in government spending and/or a decrease in taxes. This would shift the AD curve to the right increasing real GDP and decreasing unemployment, but it may also cause some inflation.Does expansionary fiscal policy cause inflation? ›
However, expansionary fiscal policy can result in rising interest rates, growing trade deficits, and accelerating inflation, particularly if applied during healthy economic expansions. These side effects from expansionary fiscal policy tend to partly offset its stimulative effects.What is expansionary fiscal policy in simple terms? ›
Fiscal policy that increases aggregate demand directly through an increase in government spending is typically called expansionary or “loose.” By contrast, fiscal policy is often considered contractionary or “tight” if it reduces demand via lower spending.How does Congress use expansionary fiscal policy? ›
Expansionary Fiscal Policy: This type of fiscal policy is used when things get too slow, commonly during a recession, and the government wants to fuel growth. Government spending increases and tax rates drop. Unemployment falls as jobs open up and more people jump back into the workforce.What is expansionary fiscal policy quizlet? ›
Expansionary Fiscal Policy. An increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output.
Why does fiscal policy shift the IS curve? ›
An expansionary fiscal policy in the form of an increase in government expenditures or a reduction in taxes shifts the IS curve to the right so that at each rate of interest the goods market is in equilibrium at a higher level of national income.What are three 3 things that fiscal policy does to influence the economy? ›
The government does this by increasing taxes, reducing public spending, and cutting public sector pay or jobs.What was Obama's fiscal policy? ›
The economic policy of the Barack Obama administration, or "Obamanomics" was characterized by moderate tax increases on higher income Americans, designed to fund health care reform, reduce the federal budget deficit, and decrease income inequality.What fiscal policy did the US use during Covid? ›
The U.S. government and the Federal Reserve (Fed) have taken steps to mitigate the effects by providing fiscal stimulus and relief. Actions on monetary policy, interest rates, quantitative easing (QE), and lending programs are several examples of how the Fed has tried to help the economy.What is the US fiscal policy 2022? ›
Reforms in early 2022 cut the top individual and corporate tax rates to 6.0 percent, and then a special legislative session in September 2022 cut the rates further to 5.8 percent.Is-LM curve explained? ›
The IS-LM graph examines the relationship between output, or gross domestic product (GDP), and interest rates. The entire economy is boiled down to just two markets, output and money, and their respective supply and demand characteristics push the economy toward an equilibrium point.What is a PPC graph in economics? ›
Term. Definition. production possibilities curve (PPC) (also called a production possibilities frontier) a graphical model that represents all of the different combinations of two goods that can be produced; the PPC captures scarcity of resources and opportunity costs.What are two effects of expansionary fiscal policy? ›
However, expansionary fiscal policy can result in rising interest rates, growing trade deficits, and accelerating inflation, particularly if applied during healthy economic expansions.What is an example of fiscal stimulus policy? ›
Examples of fiscal stimulus involve increasing public-sector employment, investing in new infrastructure, and providing government subsidies to industries and individuals.Which of the following would be considered an expansionary policy? ›
Answer and Explanation: Option (d) a decrease in taxes and an increase in government spending is correct.
What is one example of contractionary fiscal policy? ›
In the United States, the most recent large-scale use of contractionary fiscal policy came during President Bill Clinton's time in office (1993–2001), when he increased taxes on high-income taxpayers and decreased government spending on both defense and welfare.How does expansionary fiscal policy cause inflation? ›
Expansionary fiscal policy can undermine both effects, while contractionary fiscal policy can reinforce them. Specifically, spending increases and tax cuts work to boost demand in the near term, while high levels of projected deficits and debt can boost inflation expectations.What are the pros of expansionary fiscal policy? ›
The main benefit of expansionary fiscal policy is that it works very fast if done accurately. It expands profitability since it targets expanding the money supply. Also, there is a high demand for goods and services, and organizations gear ready for rising production in terms of quality and quantity.How does expansionary policy affect the economy? ›
Expansionary policies increase the availability of funds, which, in turn, leads to increased consumption and greater economic growth. Because companies have more funds available to them, they increase production, which then increases the demand for all factors of production, including human capital.