GST Software. TaxCloud Direct Tax Software. Need Help? About us. Download link sent. Category Economy. Introduction Expansionary fiscal policy is when the government increases the money supply in the economy using budgetary instruments to either raise spending or cut taxes—both having more money to invest for customers and companies.
Objective of Expansionary Fiscal Policy Expansionary fiscal policy is intended to boost growth to a healthy economic level, which is required during the business cycle's contractionary period. How Does it Function? Expansionary Fiscal Policy Examples The two significant examples include increased government spending as well as tax cuts. Related Terms. Conversely, increases in aggregate demand could run ahead of increases in aggregate supply, causing inflationary increases in the price level.
Business cycles of recession and boom are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes.
Expansionary policy can do this by:. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. Consider first the situation in Figure 2, which is similar to the U. At the equilibrium E 0 , a recession occurs and unemployment rises.
The figure uses the upward-sloping AS curve associated with a Keynesian economic approach, rather than the vertical AS curve associated with a neoclassical approach, because our focus is on macroeconomic policy over the short-run business cycle rather than over the long run. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD 1 , closer to the full-employment level of output.
In addition, the price level would rise back to the level P 1 associated with potential GDP. Figure 2. Expansionary Fiscal Policy.
The original equilibrium E 0 represents a recession, occurring at a quantity of output Yr below potential GDP. However, a shift of aggregate demand from AD 0 to AD 1 , enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of potential GDP.
Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P 0 to P 1 that results should be relatively small. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy?
After the Great Recession of —, U. This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.
The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases.
However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy.
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