Table of Contents
- What is an expansionary fiscal policy?
- What does expansionary fiscal policy do?
- What is the purpose of expansionary fiscal policy?
- Expansionary fiscal policy examples
- How does an expansionary fiscal policy affect interest rates?
- Expansionary fiscal policy graph
- Advantages of Expansionary fiscal policy
- Disadvantages of expansionary fiscal policy
- The theory of Ricardian equivalence and expansionary fiscal policy
- How expansionary fiscal policy affects an economy’s GDP
- Expansionary fiscal policy vs contractionary fiscal policy
- FAQs on expansionary fiscal policy
What is an expansionary fiscal policy?
An expansionary fiscal policy is so named because it is the action of the government which involves the expansion of money supply with the use of budgetary tools to either increase government spending or cut taxes. Both actions make more money available for consumers to spend. Therefore, an expansionary fiscal policy involves the increase in government spending or cutting taxes, or the combination of the two in order to increase aggregate demand
During a recession, if the government uses an expansionary fiscal policy to increase GDP, the growth of the economy will be accelerated. Also, the aggregate demand curve will shift to the right. This is because, during this period, the economy operates below the level of full employment and the economic growth is slow. According to monetarists, an expansionary fiscal policy aims at increasing the supply of money in an economy.
The government employs an expansionary fiscal policy when the economy is below full employment in order to reduce the rate of unemployment and increase economic activities. Therefore, if an economy is in a recession, expansionary fiscal policy will increase aggregate demand thereby stimulating economic growth.
Expansionary fiscal policy is less effective in an open economy because an increase in government expenditure can bring about an increase in interest rates thereby increasing 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 that came about through borrowing will bring about an increase in the interest rate which in turn reduces investment. In essence, the act of rising public sector tends to drive down or even eliminate the 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 pursues an expansionary fiscal policy if it notices that the economy is contracting. By government spending such as the use of subsidies, social welfare, education, transportation, and cutting down taxes, expansionary fiscal policy will bring about an increase in consumption and investment. This is because more disposable income is left in the hands of consumers and investors.
Also, the rate of unemployment reduces as an increase in consumption brings about an increase in the 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 activities and growth.
Aggregate demand and consumer spending are two major factors that stimulate the growth of an economy. Cutting down corporate tax makes more money available in the hands of businesses. In turn, the government hopes that this money will be put towards new investments thereby increasing employment. This implies that tax cuts help in the creation of more jobs. However, if the company already has enough cash, it may use the tax cuts as means of buying back stocks or purchasing new companies. The supply-side economics theory recommends that the government lowers corporate taxes instead of income taxes and also agitates for lower capital gains taxes in order to bring about 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 more.
What is the purpose of expansionary fiscal policy?
The purpose of an expansionary fiscal policy is to accelerate economic growth by increasing aggregate demand through economic stimulus. By implication, an increase in government spending and a reduction in taxes increases the money supply in the economy thereby increasing the level of consumption in the economy. Hence, this government activity increases economic activity bringing about an economic boom.
According to the theory of Keynesian economics, expansionary fiscal policy, as well as expansionary monetary policy, is one of the most effective tools available for the government to promote economic activities during a period of recession. As earlier stated, during a recession, there is a fall in aggregate demand, and businesses and consumers cut down their spending as well. This also implies a fall in aggregate demand which can bring about a vicious cycle if the government leaves it unchecked. This is a situation whereby weak consumer demand brings about fewer investments on part of businesses which brings about a further depression of the demand. It is necessary for the government to counter this cycle. An expansionary fiscal policy is very critical for this action. The expansionary fiscal policy tools are tax cuts and increases in government spending.
The government uses this as a mechanism for boosting economic growth to a healthy level as it is necessary for the contractionary phase of the business cycle. However, an expansionary fiscal policy can result in inflation.
Expansionary fiscal policy examples
The following are some examples of expansionary fiscal policy in action;
- An example of expansionary fiscal policy would be the government spending on the construction of bridges or roads in order to create more jobs and increase the income of the people.
- In the administration of Donald Trump, there was an implementation of the expansionary fiscal policy with tax cuts and the Jobs Act. There was also an increase in discretionary spending, especially for national defense.
- In the administration of Obama, the government used the expansionary fiscal policy with the Economic Stimulus Act, The American Recovery and Reinvestment Act cut down tax rate as well as extended employment benefits. They also funded public works projects as well as other public expenditures. The enacted law in 2009 was meant to stimulate economic activities and growth as the economy was losing its strength. The cost of tax cuts and government expenditure was $787 billion, which occurred while tax receipts dropped.
- The administration of George Bush made use of the expansionary fiscal policy to put an end to the economic recession in 2001, cutting income taxes with the Economic Growth and Tax Relief Reconciliation Act which mailed out the reduction in tax payments. It was unfortunate that the terrorist attacks that took place brought about a reoccurrence of an economic downturn. Bush launched the War on Terror as well as cut business taxes in 2003 with the Jobs and Growth Tax Relief Reconciliation Act. As of 2004, the economy returned to good shape with unemployment going down to 5.4 percent.
- The administration of President John F. Kennedy made use of the expansionary fiscal policy to boost the economy, bringing it out of the 1960 recession. He made a vow to sustain the policy until the recession came to an end irrespective of the impact on the debt.
- In order to end the Great Depression, President Franklin D. Roosevelt made use of the expansionary policy. Initially, this policy worked but then, he made a reduction in the New Deal spending in order to balance the budget. Consequently, this gave Depression room to reappear in 1932. However, Roosevelt brought back the expansionary fiscal policy to help to gear up for the Second World War.
Other examples of expansionary fiscal policy include the building of roads, schools, factories, and a reduction of income taxes to increase purchasing power as well as get rid of a decrease in demand.
How does an expansionary fiscal policy affect interest rates?
As emphatically stated, the goal of an expansionary fiscal policy is to increase aggregate demand in the economy, that is, with the increase of government spending and reduction in taxes.
Expansionary fiscal policy can bring about higher interest rates. If this happens, it will discourage firms and households from borrowing and spending which will, in turn, reduce aggregate demand. Even if lower aggregate demand resulting from higher interest rates does not offset the direct effect of expansionary fiscal policy, the power of fiscal policy may become less than originally expected. This refers to crowding out where government spending and borrowing bring about an increase in interest rates thereby reducing household consumption and business investment.
It is important to note that private investment is not crowded out in this case as the expansionary fiscal policy can take the form of an increase in the investment component of government purchases and expenditure. The government purchases goods such as office supplies and services. However, the government can also purchase investment items such as roads and schools. It is in this case that there may be a crowding out of private investment by the government investment.
The opposite of crowding out occurs in the contractionary fiscal policy where there is a cut in government purchases (or transfer payments), an increase in taxes, or both. Such measures bring about a reduction in the deficit and bring about an increase in the surplus. This would reduce government borrowing and shift the supply curve for bonds to the left.
It is clear that crowding out weakens the impact of fiscal policy. So crowding out occurs when expansionary fiscal policy leads to higher government expenditure by the government. However, an effective expansion will bring about healthy economic growth.
Expansionary fiscal policy graph
An expansionary fiscal policy is best represented by a graph; In the graph below, you will see that the original equilibrium Eo is a representation of an economic recession that occurs at a quantity of output Yr which is below the potential GDP. However, a shift in the aggregate demand from AD1 to AD2 which came about through an expansionary fiscal policy can bring the economy to a new equilibrium output, that is from E1 to E2 at the potential GDP level. As a result of the fact that the economy was producing below potential GDP, an inflationary increase in the price level from P1 to P2 results will be relatively small.
Advantages of Expansionary fiscal policy
- The goal of expansionary fiscal policy is to increase productivity
- Expansionary fiscal policy is used to fuel economic growth
- Increase in employment
- Another goal of expansionary fiscal policy is to restores consumer and business confidence
- Increase in productivity
Since this type of fiscal policy aims at increasing the supply of money, productivity increases correspondingly. The demand for goods and services increases and this causes companies to prepare to increase their production in terms of quantity and quality.
Fuels economic growth
This fiscal policy helps in fueling the growth of a nation’s economy especially in the phase of recession. This makes the adoption of the expansionary policy to be necessary during the phase of low growth. With this, there is a reduction in the restrictions on loan applications as well as interest rates. In turn, this brings about an increase in the flow of capital into the economy.
Increase in employment
When there is an increase in profits and revenue, there will be a corresponding increase in the demand for labor. As it becomes easier to borrow, it becomes profitable for companies to recruit new employees thereby reducing unemployment.
Restores consumer and business confidence
Consumer and business confidence is a vital factor for the continuous growth of an economy and this is restored by expansionary fiscal policy. This is because they have it at the back of their minds that the government will steps that are necessary to end the recession as this is critical for them to start spending again. If confidence is absent, everyone will keep his money without spending or investing.
Disadvantages of expansionary fiscal policy
- Increase in government expenditure
- The absence of price stability on different products
- Excess supply of money
Increase in government expenditure
This fiscal policy tends to increase government expenditure and this brings about a reduction in taxation. When there is a reduction in taxes, the economy will experience a deficit in its budget. In turn, there will be a high rate of borrowing and a rise in government debt.
The absence of price stability on different products
On various products, there is an absence of price stability. This is because the increase in the supply of money causes it to lose its importance when it comes to related products. Also, higher costs are set for goods that are limited in quantity.
Excess supply of money
If the economy is at full employment, expansionary fiscal policy is most likely to lead to inflation. Inflation means an excess supply of money in the economy pursuing few goods which brings about a persistent rise in prices. An increase in inflation brings about unnecessary problems in an economy. Therefore, it is critical for the government to be very careful while employing this economy. It should not just focus on the growth of the economy but stability as well.
The theory of Ricardian equivalence and expansionary fiscal policy
The theory of Ricardian equivalence argues that expansionary fiscal policy will be ineffective because investors and consumers will understand that governments will eventually have to pay debts in the form of future taxes. It is an economic theory that states that the act of financing government spending out of current or future taxes as well as current deficits will have equivalent effects on the entire economy. This theory also argues that individuals will save on the basis of how they expect the government will levy increased future taxes in order to pay off the debt and this will bring about compensation of the increase in aggregate demand from the increase in government spending. By implication, the Keynesian fiscal policy will not be effective in boosting economic output and growth on a general note.
This theory was propounded by David Ricardo in the early 19th Century and Professor Robert Barro (Harvard professor) elaborated on it. It is for this reason that the Ricardian Equivalence is also known as the Barro-Ricardo equivalence proposition.
In essence, this theory proposes that government deficit spending is equivalent to spending out of current taxes. Because of the fact that taxpayers will save more to pay the expected future taxes, there is a tendency for this to compensate for the macroeconomic effects of increased government spending.
How expansionary fiscal policy affects an economy’s GDP
Expansionary fiscal policy can have an impact on an economy’s gross domestic product (GDP) through the fiscal multiplier. The fiscal multiplier should not be confused with the monetary multiplier. It is the ratio of a change in national income to the change in government spending that brought about the change. When this multiplier is greater than one (1), then the enhanced effect it will have on national income is referred to as the multiplier effect.
The multiplier effect comes about when an increase in the amount of government spending brings about an increase in income and consumption which further increases income. If income further increases, consumption will further increase as well and the cycle continues. This will bring about an overall increase in national income that is greater than the initial increased amount of spending. In other words, when there is an initial change in aggregate demand, there will also be a change in the 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 efficacy of government spending or tax cuts to stimulate aggregate demand in the economy.
For example, if an economy’s government decides to spend $ 1 million in building a plant, this does not mean that the money will just disappear. Part of this money will become wages to builders and another part of the money will become revenue to suppliers, and so on. With this, the builders will have more disposable income which will bring about an increase in consumption. In this case, aggregate demand will certainly rise. Furthermore, if recipients of the new spending made by builders raise more demand and consumption increases, the output by the recipients of the builders’ income will also increase. The increase in the GDP will then be the sum of the increases that took place in the net income of everyone that was affected.
Expansionary fiscal policy vs contractionary fiscal policy
Generally, expansionary fiscal policy is the opposite of contractionary fiscal policy.
By definition, expansionary fiscal policy refers to the policy that the government adopts which is geared towards promoting consumption in the economy which aims at expanding the economy. On the other hand, a contractionary fiscal policy is a fiscal policy that the government adopts in order to contract the economy.
These fiscal policies both have an impact on the aggregate demand of an economy but these impacts differ. While expansionary fiscal policy increases aggregate demand, the reverse is the case for contractionary fiscal policy, that is, it results in the reduction of the 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.
Also, expansionary policy brings about an increase in the purchasing power of individuals and companies while contractionary fiscal policy brings about a decline in purchasing power.
The fact remains that the government uses expansionary fiscal policy to boost the economy which may result in inflation if left unchecked. On the other hand, the government uses contractionary fiscal policy to keep inflation in check.
The expansionary fiscal policy brings about an increase in the fiscal deficit. On the other hand, a contractionary fiscal policy brings about a decrease in the fiscal deficit.
FAQs on expansionary fiscal policy
What is the main objective of expansionary fiscal policy?
The main objective of expansionary fiscal policy is to bring an economy out of recession as well as to prevent economic depression. In essence, the aim is to increase aggregate demand and stimulate economic growth.
What does expansionary fiscal policy affect?
Expansionary fiscal policy affects the level of income of individuals, aggregate demand business output, consumption, investment, and employment. This is because tax cuts leave individuals with more disposable income which in turn shift their demands upwards.
On part of businesses and industries, they are being pushed to produce more. This calls for the need to employ more workers thereby reducing unemployment. Also, government spending on basic amenities, education, and welfare also offers more opportunities and income for individuals and businesses. With more income, consumption and investment increase.
Why is an expansionary fiscal policy used?
An expansionary fiscal policy is used by the government to increase aggregate demand in the economy. It is a tool that helps in curbing economic recession and preventing the economy from getting to the stage of depression. When the government stimulates economic activities using this economic tool, the economy will grow. In this case, through tax cuts and an increase in government spending, there will be a decrease in unemployment.
Employment opportunities come about as a result of an increase in aggregate demand. There is more money in the hands of businesses and individuals to invest and spend which brings about the increase in aggregate demand. When the aggregate demand increases, there will be a need for industries to produce more which will equally call for the employment of more workers. Therefore, spending increases, aggregate demand increases, production increases, and the cycle continues. In essence, as more workers are being employed, there is more disposable income.
What is the most expansionary fiscal policy?
Expansionary fiscal policy involves tax cuts and an increase in government expenditure.
What is an example of an expansionary fiscal policy?
An example of expansionary fiscal policy would be the government cutting income taxes and spending on projects such as the building of roads, schools, bridges, and factories to promote economic activities
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.