Economics » Government Budgets and Fiscal Policy » Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

Expansionary Fiscal Policy

Expansionary Fiscal Policy

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 (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. 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. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in this figure, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

Expansionary Fiscal Policy

The graph shows two aggregate demand curves that each intersect with an aggregate supply curve. Aggregate demand curve (AD sub 1) intersects with both the aggregate supply curve (AS sub 0) as well as the potential GDP line.

The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which is shown by the LRAS curve. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 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 2008–2009 (which started, actually, in very late 2007), U.S. government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009. 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. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. 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.

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.


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