Expansionary Fiscal Policy
What Is Expansionary Fiscal Policy?
Expansionary fiscal policy involves the government increasing spending or decreasing taxes to stimulate economic activity.
Expansionary fiscal policy is used by the government to respond to periods of recession or low economic growth to try and spur some activity.
The thought behind this type of policy is that by increasing demand through government spending, businesses will expand production to meet this higher demand.
This in turn will lead to more jobs and higher incomes, which boosts consumption and further stimulates economic activity.
Many also view expansionary monetary policy as the “humane” thing to do in many cases.
There’s a certain amount of spending that’s needed and governments can create their own money. Accordingly, they can spend in ways that people and corporations can’t.
Expansionary Fiscal Policy – Key Takeaways
1. Expansionary fiscal policy is when the government spends more money or taxes less to try and stimulate the economy.
2. Expansionary fiscal policy can lead to inflation if it is overdone.
3. expansionary fiscal policy is often used during recessions.
4. Done in the appropriate doses at the appropriate times, expansionary fiscal policy can be an effective way to jumpstart a struggling economy.
Expansionary Fiscal Policy Tools
There are a few ways that the government can enact expansionary fiscal policy.
1) One way is for the government to increase spending on goods and services.
2) Another way is for the government to decrease taxes so that individuals and businesses have more money to spend.
3) The government can also increase transfer payments, which are payments made to individuals or businesses that are not in return for any goods or services.
4) Expansionary fiscal policy can also be accomplished through the use of tax credits, which are reductions in the amount of taxes that a person or business owes.
Benefits of Expansionary Fiscal Policy
There are a few potential benefits of expansionary fiscal policy.
1) One benefit is that it can help to stimulate economic activity and prevent or lessen the effects of a recession.
2) Another benefit is that it can help to create jobs and reduce unemployment. This can lead to a type of self-sustaining flywheel effect where the income created by the government spending leads to more spending and investment, which creates new output, which leads to more spending, and so on.
3) Expansionary fiscal policy can also help to reduce inequality by increasing the incomes of lower- and middle-income households.
Drawbacks of Expansionary Fiscal Policy
There are a few potential drawbacks of expansionary fiscal policy as well.
1) One drawback is that it can lead to higher government debt levels if the extra spending is not paid for with cuts in other areas or increased revenue.
Ultimately, is the spending productive? Does it create more in output than the costs incurred?
2) Another drawback is that it can cause inflation if the economy is already near full capacity (often indicated by low unemployment rates) and there is not enough slack in the system to accommodate the additional demand from government spending.
3) Expansionary fiscal policy can also be less effective in stimulating economic activity if people expect taxes to increase in the future to pay for the extra government spending. This can lead to people saving rather than spending the extra money, which defeats the purpose of the policy.
This can also depend on who gets the money. If the money goes toward those who need it most (i.e., they have a higher marginal propensity to consume) it’s more likely to get spent and fulfill its intended purpose. For those who are more well-off they’re more likely to save or invest the money, so the benefit to the broader economy may be very indirect or come later.
This is a common criticism of quantitative easing (QE) policies, which are under the realm of monetary policy – it benefits asset holders, who are less likely to use their investment gains to spend in the real economy, which creates the incomes for others.
Expansionary Fiscal Policy | Macroeconomics
Choosing the Right Fiscal Policy
When choosing a fiscal policy, it is important to consider the goals that policymakers are trying to achieve and the trade-offs that they are willing to make.
If their goal is to stimulate economic activity in the short-term, then expansionary fiscal policy may be a good option.
However, they need to be aware of the potential drawbacks (most notably inflation, asset bubbles, and currency devaluation) and be willing to accept them in order to get the benefits.
Expansionary Fiscal Policy Examples
There are a few examples of expansionary fiscal policy that have been enacted in recent years.
1) One example is the American Recovery and Reinvestment Act of 2009, which was passed in response to the Great Recession.
2) Another example is the Tax Cuts and Jobs Act (TCJA) of 2017, which decreased taxes for individuals and businesses.
3) In 2022, the UK government sought to cut taxes to stimulate growth. However, these tax cuts were unfunded and inflation was already high. It was largely considered a fiscal blunder.
Traders responded to the UK bill by selling gilts (increasing interest rates) and selling GBP, given it widened deficits in a way that weren’t funded, with private market participants unwilling to buy the debt that would have been created to help fund the deficits.
Expansionary Fiscal Policy & the Crowding Out Effect
The crowding out effect of expansionary fiscal policy suggests that when the government increases spending, it crowds out private investment.
This is because the government is using up resources that would otherwise be available for private use, and it can also lead to higher interest rates as the government competes with private borrowers for funds.
The crowding out effect can reduce the overall effectiveness of expansionary fiscal policy.
However, there are a few ways to minimize the crowding out effect.
1) One way is to target government spending toward areas that are underdeveloped or have high unemployment.
2) Another way is to use tax cuts rather than increased spending to stimulate economic activity.
3) Finally, the government can seek to increase private investment through other means, such as tax incentives.
Expansionary Fiscal Policy & Keynesian Economics
The ideas behind expansionary fiscal policy are closely related to Keynesian economics.
Keynesian economics suggests that government spending can be used to increase aggregate demand and reduce unemployment.
There are a few key differences between expansionary fiscal policy (in generalized form) and Keynesian economics.
1) Expansionary fiscal policy is typically used in response to a recession or other economic downturn, while Keynesian economics suggests that government spending should be increased even when the economy is doing well in order to prevent a recession.
2) Keynesian economics suggests that government spending should be financed by borrowing, while expansionary fiscal policy can be financed either through borrowing or using existing surpluses.
Expansionary Fiscal Policy vs Contractionary Fiscal Policy
Expansionary fiscal policy is the opposite of contractionary fiscal policy.
Contractionary fiscal policy seeks to slow down the economy by reducing government spending and/or increasing taxes.
Contractionary fiscal policy is typically used during periods of high/above-target inflation in order to reduce aggregate demand and bring inflation back down to target levels.
This is because the impacts of the high inflation are worse than the growth coming from the spending.
There are a few key differences between expansionary fiscal policy and contractionary fiscal policy.
1) Expansionary fiscal policy increases government spending and/or decreases taxes, while contractionary fiscal policy reduces government spending and/or increases taxes.
2) Expansionary fiscal policy is typically used in response to an economic downturn, while contractionary fiscal policy is typically used in response to high inflation.
3) Expansionary fiscal policy can have some drawbacks, such as the crowding out effect and inflation, while contractionary fiscal policy can also have some drawbacks, such as recession and unemployment.
These influences have to be balanced against each other.
Expansionary Fiscal Policy – Inflation
Economies have a certain capacity to them.
There’s a certain amount of labor (which combines with outputs such as technology and machines) to create output.
That output is known as supply.
Then there’s a certain demand for that supply of goods and services.
Demand comes in the form of money and credit.
When there’s too much money and credit in relation to the supply of goods available, inflation will result out of it.
Most policymakers and most people tend to agree that the point where inflation has a negative impact on productivity is somewhere around two percent annually.
At that point, inflation can start to distort economic decision-making and lead to worse productivity outcomes.
Expansionary fiscal policy, then, can inadvertently lead to inflation if it’s overdone or not pursued appropriately.
Expansionary Fiscal Policy – Interest Rates
If expansionary fiscal policy leads to above-target inflation, then it may cause nominal interest rates to rise.
If interest rates rise, then that will tend to lead to a decrease in investment spending.
That’s because when interest rates are higher, it becomes more expensive to borrow money for investments.
So, if expansionary fiscal policy is not done correctly, it may unintentionally lead to lower levels of investment spending.
Expansionary Fiscal Policy vs. Contraction Monetary Policy
Expansionary fiscal policy and contractionary monetary policy are ways of influencing economic activity.
Both expansionary fiscal policy and contractionary monetary policy can be used to either stimulate economic growth or slow it down.
The main difference between the two is that expansionary fiscal policy consists of government spending and taxes while contractionary monetary policy uses interest rates and transactions of securities (mostly government bonds).
Expansionary fiscal policy is typically used in response to an economic downturn, while contractionary monetary policy is typically used in response to high inflation.
Can expansionary fiscal policy and contractionary monetary policy occur at the same time?
Yes. Expansionary fiscal policy may lead to inflation, which may cause the central bank to run contractionary monetary policy.
This can occur in cases where elected officials have political incentives to run policy in an expansionary way while the central bank (which is supposed to be an independent entity) will fight any inflationary forces that come out of it.
FAQs – Expansionary Fiscal Policy
What is the definition of expansionary fiscal policy?
Expansionary fiscal policy is a type of economic policy that is typically used by to increase spending or lower taxes to stimulate spending.
Expansionary fiscal policy can be used in response to an economic downturn, such as a recession, to try to increase aggregate demand and reduce unemployment.
However, expansionary fiscal policy can also have some drawbacks, such as the crowding out effect and inflation.
When choosing a fiscal policy, it is important to consider the goals that policymakers are trying to achieve and the potential trade-offs.
What are the tools of expansionary fiscal policy?
The tools of expansionary fiscal policy are:
1) Increasing government spending
2) Decreasing taxes
3) Increasing transfer payments
4) Using tax credits
What are the benefits of expansionary fiscal policy?
The benefits of expansionary fiscal policy are:
1) It can help to stimulate economic activity
2) It can create jobs and reduce unemployment
3) It can help to reduce inequality
What are the drawbacks of expansionary fiscal policy?
The drawbacks of expansionary fiscal policy are:
1) It can lead to higher government debt levels if the extra spending is not paid for from productivity benefits
2) It can cause inflation if the economy is already near full capacity
3) People may save rather than spend the extra money, which would defeat the purpose of the policy
How do you choose the right fiscal policy?
When choosing a fiscal policy, it is important to consider the goals that you are trying to achieve and the trade-offs that you are willing to make.
If your goal is to stimulate economic activity in the short-term, then expansionary fiscal policy may be a good option.
However, you need to be aware of the potential drawbacks (e.g., higher inflation, higher interest rates, asset bubbles, currency devaluation) and be willing to deal with those trade-offs in order to get the benefits.
How does fiscal policy affect the economy?
Expansionary fiscal policy will most likely result in more money being available for the purchase of goods, services, and financial assets via more government spending (which provides income) or tax cuts.
Expansionary fiscal policy leads to an increase in aggregate demand (AD), holding all else equal, which is the total demand for all goods and services in an economy.
When AD increases, businesses will generally try to expand production to meet this higher demand. This in turn is likely to lead to more jobs and higher incomes, which boosts consumption and further stimulates economic activity.
What are the goals of expansionary fiscal policy?
The goals of expansionary fiscal policy are to stimulate economic growth and create jobs.
The hope is that by increasing spending or decreasing taxes, businesses will have more money to invest in their operations and hire new workers.
This extra spending can help to jumpstart the economy and get it back toward producing at its capacity after a period of slower growth.
What are some examples of expansionary fiscal policy?
Some examples of expansionary fiscal policy are:
1) The government increasing spending on infrastructure projects
2) The government decreasing taxes for businesses
3) The government increasing transfer payments (e.g., unemployment benefits, food stamps)
4) The government providing tax credits for businesses that invest in new equipment or hire new workers
When is expansionary fiscal policy used?
The goal of expansionary fiscal policy is to increase economic growth.
It is typically used during periods of economic slowdown or recession as a way to try and get the economy going again.
Expansionary fiscal policy can also be used to fight inflation if the economy is already near full capacity.
By increasing government spending or decreasing taxes, it can help to cool down an overheating economy.
What are the risks of expansionary fiscal policy?
There are a few risks associated with expansionary fiscal policy:
1) It can lead to higher government debt levels if the extra spending is not paid for.
This can lead to a “debt trap” where a country may struggle to raise interest rates when appropriate or see its currency fall given the burden the extra interest expense would place on government finances. Japan is a modern example.
2) It can cause inflation if the economy is already near full capacity
3) People may save rather than spend the extra money, which would defeat the purpose of the policy
4) It can lead to asset bubbles if the money is not spent wisely. Does it go toward productive spending or go toward financial speculation?
What are the benefits of expansionary fiscal policy?
The benefits of expansionary fiscal policy are:
1) It can help to stimulate economic activity in the short-term
2) It can help to create jobs and reduce unemployment
3) It can help to reduce inequality
Overall, expansionary fiscal policy can be a helpful tool for jumpstarting the economy or fighting inflation.
However, it is important to be aware of the potential risks before implementing such a policy.
What does expansionary fiscal policy do to interest rates?
It depends.
It largely depends on the impact on inflation.
When expansionary fiscal policy is simply helping demand meet supply, there is minimal inflationary impact from the policy itself. So there shouldn’t be much of an impact on interest rates.
However, when expansionary fiscal policy is used to try and increase economic growth beyond what is sustainable, it can lead to inflation. In this case, the central bank may need to raise interest rates in order to tame inflationary pressures.
So while there is no definitive answer, the impact of expansionary fiscal policy on interest rates heavily depends on its impact on inflation.
Summary
Expansionary fiscal policy is so named because it is intended to expand the economy by increasing spending or decreasing taxes.
The goals of expansionary fiscal policy are to stimulate economic growth and create jobs, which create greater output.
There are a few potential drawbacks of expansionary fiscal policy as well, such as higher government debt levels, inflation, and less effectiveness if people expect taxes to increase in the future.
When choosing a fiscal policy, it is important to consider what policymakers are trying to achieve and the associated trade-offs they’re making.
If the goal is to stimulate economic activity in the short-term, then expansionary fiscal policy may be a good option.
However, they need to be aware of the potential drawbacks and be willing to accept that they may surface in order to get the benefits.
Expansionary fiscal policy will most likely result in more money being available for the purchase of goods, services, and financial assets.
Some examples of expansionary fiscal policy include increasing government spending on infrastructure projects or cutting taxes for businesses.