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What Is Expansionary Fiscal Policy?
An expansionary fiscal policy seeks to increase aggregate demand through a combination of increased government spending and tax cuts. The idea is that by putting more money into the hands of consumers, the government can stimulate economic activity during times of economic contraction (for example, during a recession or during the contractionary phase of the business cycle).
While expansionary policies necessarily increase the budget deficit or decrease surpluses in the short term, the idea is that by stimulating more economic activity, the overall economy will expand (hence the name), making up for short-term deficits with long-term economic growth. This is because even a relatively limited stimulus, if smartly targeted, can have a multiplier effect across the entire economy.
The flipside of expansionary fiscal policy is contractionary fiscal policy, which involves raising taxes or decreasing government spending in order to “tap the brakes” on economic growth.
What Is the Purpose of Expansionary Fiscal Policy?
According to Keynesian economic theory, expansionary fiscal policy is one of the most effective tools (along with an expansionary monetary policy) governments have to promote economic activity during periods of recession. During these periods, aggregate demand falls as businesses and consumers cut back on their spending.
If left unchecked, a drop in aggregate demand can create a vicious cycle, whereby weak consumer demand leads businesses to invest less, which further depresses demand, and so on. To counter this cycle, an expansionary fiscal policy has two essential tools:
- Tax cuts, whether they take the form of overall rate reductions or refundable credits put more money directly into the pockets of consumers.
- Increased government spending, often on public works, in order to increase the overall level of employment.
Notice that in the case of both options, the most basic goal of expansionary fiscal policy is to increase demand in the economy by giving people more disposable income, both to spur consumer spending and business investment.
This is different from an expansionary monetary policy, which relies on issuing bonds and lowering interest rates in order to spur lending on the part of banks and increase the money supply.
How Is Expansionary Fiscal Policy Implemented?
In the United States and most other developed countries, fiscal policy is decided by the executive and/or legislative branches. In the U.S., Congress sets fiscal policy through the federal budget and appropriations bills, which the president must then sign into law.
It’s important to note that when economists and policymakers talk about increasing spending to juice the economy, they’re usually talking about discretionary spending—that part of the federal budget that isn’t already earmarked for programs like Social Security and Medicare as mandated by law. It also typically excludes defense spending, which makes up the majority of discretionary spending in the U.S.
Another important thing to note is that governments don’t always use the tools of fiscal policy as intended. Because fiscal policy tends to be the prerogative of the executive and legislative functions, it’s often more subjective to political influence than monetary policy, which is generally handled by central banks. For example, politicians are sometimes tempted to cut taxes outside of a contractionary period in an effort to boost the economy in order to win re-election, even at the risk of sparking a boom-and-bust cycle.
An Example of Expansionary Fiscal Policy: the ARRA
For a relatively recent example of an expansionary fiscal policy in action, look at the global recession of 2007-2009. Sparked by a severe financial crisis, the recession resulted in millions of job losses and a sharp contraction in GDP. In response, the U.S. Congress and the Obama administration passed a series of tax cuts and spending measures collectively known as the American Recovery and Reinvestment Act (ARRA).
The components of the ARRA are a classic set of expansionary fiscal policies, including:
- Tax incentives for businesses and individuals ($288 billion)
- Fiscal stimulus for state and local governments ($144 billion)
- Increased federal spending ($357 billion) on a range of federal programs, including transportation, infrastructure, energy efficiency upgrades, scientific research, and unemployment benefits
Most analysts agree that the ARRA succeeding in boosting Real GDP and reducing the unemployment rate.
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