Impact of Expansionary Fiscal Policy

Readers Question: what are the impacts of expansionary fiscal policy?

Expansionary fiscal policy involves government attempts to increase aggregate demand. It will involve higher government spending and/or lower tax. In theory, higher government spending will increase aggregate demand AD=(C+I+G+X-M) and lead to higher economic growth.AD=(C+I+G+X-M) and lead to higher economic growth.

Expansionary Fiscal Policy

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Impact of expansionary fiscal policy to increase AD

Lower taxes should increase the disposable income of consumers leading to higher levels of consumer spending. This should also increase aggregate demand and could lead to higher economic growth.

Expansionary fiscal policy can also lead to inflation because of the higher demand in the economy.

Expansionary fiscal policy and government borrowing

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In 2009/10, UK government borrowing increased as they pursued expansionary fiscal policy.

A potential problem of expansionary fiscal policy is that it will lead to an increase in the size of a government’s budget deficit. Higher borrowing could:

  • Cause markets to fear debt default and push up interest rates on government debt.(this happened in Eurozone without Central Bank to purchase bonds, but bond yields fell in UK/US due to strong demand for bonds.

Evaluation of expansionary fiscal policy

The impact of expansionary fiscal policy will depend on many factors:

1. What else is happening in the economy?

  • Lower income tax may fail to boost AD if we also have falling house prices and low confidence.
  • For example in 2008, the US tried to cut taxes; in theory, this lower tax should boost spending. However, the economy was also experiencing falling house prices, lower confidence and a shortage of credit; because of all these factors, expansionary fiscal policy was relatively ineffective in promoting rapid economic growth.

2. Crowding out

  • Crowding out occurs when the government spends more, but because they borrow from the private sector, the private sector reduces private sector investment and therefore government spending ‘crowds out’ private sector spending.
  • However, in a liquidity trap/recession, private saving rates rise rapidly. Therefore, expansionary fiscal policy helps to offset the rise in private sector saving and injects money into the circular flow and doesn’t cause crowding out.

3. Timing of fiscal policy – amount of spare capacity

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The impact of an increase in AD depends on situation of the economy.

 

  • A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP.
  • In a deep recession, with spare capacity in the economy, expansionary fiscal policy won’t cause crowding out or inflation. (AD1 to AD2 causes real GDP to rise from Y1 to Y2.)

Supply side effects of fiscal policy

  • Lower income tax may increase incentive to work
  • Higher government spending on education and training, could increase long-term labour productivity. But, also government spending could be inefficient and wasteful – it depends what government spends on.

Related

13 thoughts on “Impact of Expansionary Fiscal Policy

  1. Compare and contrast the effect of an expansionary fiscal policy in both the classical and simple Keynesian models

  2. wouldn’t the government try to stimulate the economy when the economy overheats and it leads to deflation by using a decrease in taxation and more govenment spending ? :S

    1. Yes, well, if with deflation you mean recession, then yes. What you said was a mini summary of what was written above.

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