Expansionary fiscal policy vs. contractionary fiscal policy

By: Marc Mance

 

Last week, we were not able to discuss much due to our 3 classes in the 4 day week but out of what were given through handouts, I have decided to compare expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy involves government attempts to increase aggregate demand and contractionary fiscal policy describes a reduction in the amount of money used by the government or a growth in the amount of money bought in, usually through taxes.

To compare the two types of fiscal policies; we see that the aggregate demand increases in the expansionary policy. According to Keynesian economics, if the economy is producing less than potential output, the government spending can be used to employ idle resources and boost the output. When there is an increase in government spending, it will lead to an increase in aggregate demand which then leads to an increase in the real GDP, resulting in a rise in prices. On the other hand, the government can adopt a contractionary policy and decrease government spending which decreases the aggregate demand and the real GDP, resulting in a decrease in prices.

Effects of expansionary fiscal policy

·         Investment

o   Investment can be affected by increasing the government expenditures to help boost the economy. This type of fiscal policy is used by the government to influence the level of aggregate demand in the economy through price stability and economic growth which promoted further investment into firms.

·         Interest rates

o   While the contractionary fiscal policy pulls the interest rate down, expansionary fiscal policy pushes them up. When output increases, the price level increases as well. As the price level rises, people demand more money to purchase goods and services. Since there is no change in the money supplied, this increased demand for money leads to an increase in the interest rates.

Effects of contractionary fiscal policy

·         Government purchasing

o   Involves a decrease in government spending to assorted agencies which then reduce their purchases which decease the aggregate production, income and the rate of inflation

·         Taxes

o   Involves an increase of the income tax rates which provides the household sector with less disposable income that can be used for consumption expenditures which then reduces aggregate production and employment and leads to further decreases in income.

Example

An economist named Abigail Noble is assisting the International Monetary Fund (IMF) in developing policy recommendations for different economies. She met with finance ministers of newly formed states of Sacramento and Salamia.

Sacramento has an inflation rate of 7% as compared to the average of 3%, unemployment rate of 2% as compared with natural unemployment rate of 4%, budget deficit of 5% and a GDP growth rate of 6% as compared to the average growth rate of 3%. Salamia has 1% inflation, 8% unemployment as compared to average of 4%, budget surplus of 4% and GDP growth rate of 1.5%.

Due to Salamia’s low inflation, high unemployment, a budget surplus and a low growth rate, statistics clearly show that it is facing recessionary pressures which make expansionary fiscal policy very appropriate for this situation. By decreasing taxes and increasing government spending, it will eliminate the budget surplus, increase growth rate, increase inflation and decrease unemployment. On the other hand, Sacramento has high inflation, low unemployment, a budget deficit and a high growth rate shows that it is facing inflationary pressures which make contractionary fiscal policy appropriate for this situation. Increasing taxes and decreasing its government spending will reduce the budget deficit, decrease growth rate, decrease inflation and increase unemployment.