Expansionary fiscal policy vs contractionary fiscal policy

By the end of this section, you will be able to:

• Explain how expansionary fiscal policy can shift aggregate demand and influence the economy
• Explain how contractionary fiscal policy can shift aggregate demand and influence the economy

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure illustrates.

The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

A Healthy, Growing Economy In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.

For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery 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.

Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

Video transcript

- [Narrator] In previous videos we've talked at length about fiscal policy and in other videos we've talked at length about monetary policy. But now we're going to talk about them together because at any given time in a country there is some type of fiscal policy going on and in parallel there might be some type of monetary policy going on. But first let's just remind ourselves what fiscal policy is. This would be government changing the amount of taxes or government spending. So this is all about taxes and or and or, government, government spending. And why would that matter? Well if you change the amount of taxes you would change the amount of money that individuals and or corporations might have which might change aggregate demand. Similarly, if the government goes out there, spends more or less, that also would change aggregate demand and this could be used as a tool in order to attempt to engineer what the economy's output is. Now monetary policy on the other hand, it's very important not to, not to get confused between these two. This is all about central, central banks. And I know a lot of you might be thinking, hey isn't the central bank part of the government? And I would tell you, well it depends what country you're in and depends how you view part of the government. In the United States for example, the Federal Reserve System is quasi-independent. It is true that the executive makes appointments including the chairman of the Federal Reserve Bank, but it should be acting independently from the federal government. Now this is all about central banks changing money supply, so money supply, to impact or to target oftentimes, interest rates. And now why would this matter if we're thinking about engineering, so to speak, where we are relative to full employment output? Well with low interest rates, borrowing is cheaper so people might be willing to borrow and spend more or corporations might be willing to borrow and invest more. On the other hand if you had higher interest rates it would go the other way. Either way you have an impact on aggregate demand. So with that primer out of the way, let's look at two different scenarios for an economy. So in this first scenario, let's call this scenario one, pause the video and think about where this economy is operating relative to full employment output. Well you can see here that our equilibrium level of output, Y sub one, is below our full employment output. So here we have a negative output gap. And so from the federal government's point of view they might wanna say, hey let's do some expansionary fiscal policy in order to shift the aggregate demand curve to the right. Well what would be expansionary fiscal policy? Well you could lower taxes. That could shift aggregate demand to the right. People would have more money in their pockets. Corporations might have more money to spend with, to invest with. The other option is that the government could just directly spend more. If it spends more that also would have the impact of shifting aggregate demand to the right. But in parallel with the fiscal policy, what might the monetary policy look like? Well an expansionary monetary policy would be to increase the money supply. Increase the money supply with the goal, which would have the impact, or usually would have the impact, of lowering interest rates which would make borrowing cheaper. And so corporations might invest more and people might borrow and spend more. Either way, or especially if both is happening, you are going to shift aggregate demand to the right. So with this expansionary fiscal and monetary policy you might get to a situation like this. Maybe aggregate demand gets shifted enough so we get to a world like this. So that's aggregate demand curve two. We're now, our equilibrium level of output, we're at full employment output and our price level has gone, has gone up. And generally speaking, expansionary policy whether we're talking about expansionary fiscal policy or expansionary monetary policy, you're going to see the price level go up. Now let's look at scenario two here. What are we dealing with here? Well as you can imagine it's the opposite situation. We have a positive output gap. Our equilibrium level of output is above our full employment output. And so this is a situation where the federal government might say, hey our economy is at risk from overheating. That's typically not what they say. They tend to like it 'cause it's good for winning election. But they might say, if it's a prudent federal government, they might say hey this is the time to maybe pay down some of the government debt. Or be a little bit more fiscally responsible. And so what they might do is have a contractionary fiscal policy. So that would be taxes might increase and or government, government spending might go down. Neither of these things tend to be very popular. In general contractionary fiscal policy is not a good way to win elections. But a prudent government might be willing to do this and either of them, because of the same reasons we just talked about, might have the effect of shifting aggregate demand to the left. Similarly, the Federal Reserve might wanna do a contractionary monetary policy. And contractionary monetary policy is far more common. Where the Federal Reserve says, hey when we are producing above our full employment output inflation might get out of control. So what they might do is lower the money supply, money supply, which would have the impact, or usually would have the impact, of increasing interest rates making borrowing more expensive so people might borrow and spend less and corporations might invest less. And so either way you might have the effect of shifting aggregate demand to the left. So aggregate demand might look like this now. That's aggregate demand two. Our equilibrium level of output now is at full employment output. And now our price level, our price level, has gone down. And generally speaking, contractionary monetary policy and or contractionary fiscal policy will have the impact of at least slowing down inflation. I'll leave you there. The big takeaway here is, fiscal policy and monetary policy seldom act in isolation. Oftentimes when we're at a negative output gap you have expansionary policies in both dimensions. And in a positive output gap it might be prudent to have contractionary policies in both dimensions. Now one question you might ask is what if they go in opposite directions? What if, say, fiscal policy is expansionary while monetary policy is contractionary? Well there it depends. They might offset each other. In fact, sometimes the central bank might have a contractionary policy because they think that the federal government is being too expansionary. All interesting things to think about.

What is the difference between expansionary fiscal policy and contractionary fiscal policy?

What is the difference between contractionary policy and expansionary policy?

What are examples of expansionary and contractionary fiscal policy?

What are the 2 types of fiscal policy?