Expansionary and Contractionary Fiscal Policy - Online Tutor, Practice Problems & Exam Prep

The government utilizes fiscal policy to manage aggregate demand, responding to economic conditions. In a recession, expansionary fiscal policy increases government spending or lowers taxes, shifting aggregate demand rightward to stimulate GDP and reduce cyclical unemployment. Conversely, contractionary fiscal policy is employed during inflation, reducing spending or increasing taxes to shift aggregate demand leftward, stabilizing prices and returning GDP to potential output. Understanding these mechanisms is crucial for grasping macroeconomic stabilization and the business cycle.

Expansionary Fiscal Policy

Now, let's see how the government decides whether to increase aggregate demand with expansionary fiscal policy or decrease it with contractionary fiscal policy. So, a lot of big words there, but it's pretty simple what ends up happening here. The government can change its level of spending or taxes, right? And they're going to do it in response to the state of the economy. They want to respond to a recession or to high inflation, right?

So let's start with the first situation when we have a recession and they want to expand the economy. They want more GDP. So when the economy is in a recession, real GDP is below its potential output. Okay? So, a recession, this is where we have cyclical unemployment, right? There's unemployment because it tends to be low in a recession. So, if we look at the graph first, look what we have. We have our ADAS model, aggregate demand, aggregate supply. And here we have our long-run aggregate supply, and this is our short-run aggregate supply and aggregate demand here, right? This is our price level. So the general price in the economy. And GDP, real GDP over here, right? So this is kind of like price and quantity, similar to our supply and demand graph. Remember when we studied the ADAS model? Well, we're going to go into it a little bit here. So if it's not totally clear, go ahead and refresh on the ADAS model and come back to this video. But what we're going to do here is analyze this graph. So, our long-run aggregate supply, remember this is kind of like the potential output of the economy. In the long run, all of our resources will be in play and will produce at our potential GDP. However, in the short run, you can notice that our equilibrium here in the short run, short-run aggregate supply and aggregate demand is below that long-run GDP, right? It doesn't reach that long-run GDP. So we say we're in a recession. So what is the government going to do?

The government can use expansionary fiscal policy. And this is where the government increases spending to stimulate the economy. Remember that government spending is part of our GDP equation, right? And we want to increase our aggregate demand. And aggregate demand and GDP are very closely related here. So if government spending increases, what we're going to see is that the aggregate demand increases. The demand in the economy for goods, right? These are things that who wants these goods? The consumers, through consumption, the firms through investment, or the government through government purchases or foreigners through net exports. Well, if the government increases its demand, right? We're going to see aggregate demand shift to the right. So that's the whole goal here. We're trying to get back to that long-run equilibrium with the GDP. So, expansionary, while they're expanding they want more GDP, and just so you know, well, we'll get to that in a second. Let's see how this government increasing spending is going to stimulate the economy. By increasing government purchases here, we're increasing that aggregate demand just like we just said, right? The aggregate demand is going to increase. And like we studied in the aggregate demand, aggregate supply model, we're going to shift it to the right. It's going to shift it to the right here. So AD1 becomes AD2, and that's where we are now in the economy after the government increases its spending. So we'll see that we moved from this equilibrium down here, our short-run equilibrium, where we had, we'll say price level 1 and GDP 1. Well, by shifting aggregate demand to the right with an increase in government spending, now we're back to this long-run equilibrium, right? So, now we've reached that long-run equilibrium and we have a higher price level, right? So by increasing their spending, they're going to affect the price level by increasing, increasing the price level when aggregate demand increases, but we get back to that potential GDP over here, and that was their goal, to get back to potential GDP.

So another way that the government can increase aggregate demand—well, they increased government purchases we saw here, right? But how did we discuss another thing fiscal policy does? It affects taxes, right? And taxes will affect our consumption, our disposable income, and our consumption like we discussed in the introductory fiscal policy video. So the government can also lower taxes, which increases consumption. And we'll have the same general effect here on the graph where we're going to shift to the right, our aggregate demand, and get back to our long-run equilibrium, where our aggregate demand, short-run aggregate video.

Contractionary Fiscal Policy

All right. So now let's discuss contractionary fiscal policy. This is the opposite of expansionary. So in contractionary fiscal policy, the economy has been booming and we're now experiencing rising inflation. And the government wants to keep this inflation under control. So right now, real GDP is above its potential output. We have overemployment in the economy and increasing price levels. What do I mean by overemployment? Well, it means some people who would generally not be working are now working because there's so much opportunity for work and wages are higher; they're like, "Hey, I actually I'll work right now." Or the fact that workers are working overtime because the firms are producing so much, the economy is booming so much that workers are working more than they generally intend to. So we have overemployment. This is something unsustainable in our economy. So if we go down to the graph here, notice now where our long run aggregate supply is with our short run aggregate supply and aggregate demand. So in this situation, our short run equilibrium is beyond our potential output. How is that possible? Well, like I just said, we have this overemployment in the economy. There's too much happening right now, and it's not sustainable. So this overemployment and this unsustainably high GDP that's beyond our long run potential, well, the government's going to try and tone it back a little bit by decreasing aggregate demand. So, through fiscal policy, what they can do is they can reduce their spending to reduce inflation. So this is going to affect, just like before, it's going to affect the same equation, consumption plus investment plus government spending plus net exports. Again, we're affecting the government purchases here. Okay? And like we just discussed above, they can do, they can affect consumption as well through taxes. Right? The government can also increase taxes which reduces consumption, right? Just like we've been talking about, the higher the taxes are, the lower the disposable income and lower money available for consumption. And we'll see something similar happening on the graph, except now we're going the other way. Since they're reducing their spending, well, we're going to reduce our aggregate demand here, and it's gonna shift to the left, right? We're reducing our government spending. It's going to shift it to the left, and we'll find ourselves at this new aggregate demand where we're back in long run equilibrium. So our first spot right here, our initial short run equilibrium, we were in this place where GDP was too high. GDP was beyond our potential and price levels were high. So we were at this higher price level, and the government wanted to reduce that. So they enacted this policy. And notice what happened. At our new long run equilibrium, we're back at that potential GDP that's sustainable in the long run and the price levels have decreased, right? So this can be similar to expansionary fiscal policy and if you've studied expansionary and contractionary monetary policy, you'll see a lot of similarities with monetary policy and fiscal policy. So if you've done it before, why don't you guys compare those to see the differences and the similarities there? And if not, you'll get to do that once you get to monetary policy. Alright? Let's go ahead and pause here and we'll move on to the next video.

Here’s what students ask on this topic:

What is expansionary fiscal policy and how does it work?

Expansionary fiscal policy is a government strategy used to stimulate economic growth during a recession. It involves increasing government spending or decreasing taxes to boost aggregate demand. When the government increases its spending, it directly raises the demand for goods and services, shifting the aggregate demand curve to the right. Similarly, lowering taxes increases disposable income for consumers, leading to higher consumption and investment. This policy aims to reduce cyclical unemployment and bring real GDP closer to its potential output, thereby mitigating the effects of a recession.

What is contractionary fiscal policy and when is it used?

Contractionary fiscal policy is employed by the government to curb inflation during periods of economic overheating. It involves reducing government spending or increasing taxes to decrease aggregate demand. When the government cuts its spending, it lowers the overall demand for goods and services, shifting the aggregate demand curve to the left. Similarly, raising taxes reduces disposable income, leading to lower consumption and investment. This policy helps stabilize prices and bring real GDP back to its potential output, ensuring sustainable economic growth.

How does fiscal policy affect aggregate demand?

Fiscal policy affects aggregate demand through changes in government spending and taxation. When the government increases spending or cuts taxes (expansionary fiscal policy), aggregate demand rises, shifting the demand curve to the right. This leads to higher GDP and reduced unemployment. Conversely, when the government decreases spending or raises taxes (contractionary fiscal policy), aggregate demand falls, shifting the demand curve to the left. This helps control inflation and stabilize the economy. These adjustments are crucial for managing economic cycles and achieving long-term economic stability.

What are the main tools of fiscal policy?

The main tools of fiscal policy are government spending and taxation. By adjusting these tools, the government can influence aggregate demand and stabilize the economy. Increasing government spending directly boosts demand for goods and services, while decreasing taxes increases disposable income, leading to higher consumption and investment. Conversely, reducing government spending and increasing taxes can help control inflation by lowering aggregate demand. These tools are essential for managing economic fluctuations and achieving macroeconomic objectives such as full employment and price stability.

What is the difference between expansionary and contractionary fiscal policy?

Expansionary fiscal policy is used to stimulate economic growth during a recession by increasing government spending or decreasing taxes, which boosts aggregate demand and reduces unemployment. Contractionary fiscal policy, on the other hand, is employed to control inflation during periods of economic overheating by reducing government spending or increasing taxes, which lowers aggregate demand and stabilizes prices. The key difference lies in their objectives: expansionary policy aims to increase GDP and reduce unemployment, while contractionary policy aims to control inflation and maintain sustainable economic growth.