Fiscal policy is one of the primary tools used by governments to manage and impact the economy. A fiscal policy that is expansionary tries to stimulate economic activity by placing more money in the hands of consumers and enterprises. It is one of the primary ways governments respond to business cycle contractions and prevent economic recessions.
In this article, we will go over all you need to know about expansionary fiscal policy and how it can be used to avert or terminate recessions or high unemployment.
What is Expansionary Fiscal Policy?
An expansionary fiscal policy aims to boost aggregate demand by increasing government expenditure and cutting taxes. The notion is that by providing more money in the hands of consumers, the government can promote economic activity during periods of economic contraction (for example, during a recession or during the business cycle’s contractionary phase).
While expansionary measures inevitably increase the budget deficit or reduce surpluses in the short term, the theory is that by generating more economic activity, the total economy would expand (thus the name), compensating for short-term deficits with long-term economic growth. This is because even a small amount of stimulus, if carefully targeted, can have a multiplier effect throughout the economy.
Contractionary fiscal policy is the inverse of expansionary fiscal policy, which entails raising taxes or cutting government spending in order to “tap the brakes” on economic growth.
How Expansionary Fiscal Policy Works
Expansionary fiscal policy puts more money in the hands of consumers to give them more spending power by using subsidies, transfer payments (including welfare programmes), and income tax cuts. It also eliminates unemployment by contracting public works or hiring new government employees, both of which create demand and stimulate consumer spending, which accounts for over 70% of the GDP. Government spending, net exports, and corporate investment are the other three components of GDP.
Corporate tax cuts put more money in the hands of firms, which the government believes will be used to make new investments and create more jobs. Tax cuts create jobs in this way, but if the company already has enough cash, it may utilise the savings to buy back stocks or acquire new businesses.
The supply-side economics theory calls for lower capital gains taxes rather than lower income taxes in order to promote company investment. According to the Laffer Curve, trickle-down economics only works if tax rates are already 50% or higher.
What Is the Purpose of Expansionary Fiscal Policy?
Expansionary fiscal policy is one of the most effective tools governments have to encourage economic activity during periods of recession (together with expansionary monetary policy). Aggregate demand falls during these periods as firms and consumers cut back on their expenditure.
If left unchecked, a reduction in aggregate demand can trigger a vicious cycle in which businesses spend less, which further depresses demand, and so on. An expansionary fiscal policy has two crucial weapons for breaking this cycle:
- Tax cuts, whether in the form of lower overall rates or refundable credits, put more money in the pockets of consumers.
- Increased government spending, often on public works projects, in order to improve general employment.
It is worth noting that in both cases, the most basic purpose of expansionary fiscal policy is to enhance demand in the economy by providing people with more disposable income, so stimulating consumer spending and company investment.
This differs from an expansionary monetary policy, which depends on issuing bonds and decreasing interest rates to encourage bank lending and grow the money supply.
Advantages of Expansionary Policy
If done right, expansionary fiscal policy works quickly. Government spending, for example, should be devoted to hiring people, which immediately produces jobs and lowers unemployment. If the government can give out rebate cheques immediately, tax cuts can put money in the hands of people. The quickest solution is to increase unemployment benefits. Unemployed people are more inclined to spend every dollar they receive, but individuals with higher incomes are more likely to use tax breaks to save or invest, which does not help the economy.
Most significantly, fiscal policy that is expansionary restores consumer and industry confidence. They trust the government will take the necessary steps to resolve the recession, allowing them to resume spending. Everyone would stuff their money under the mattress if they didn’t have faith in that leadership.
The Risks of Expansionary Monetary Policy
Expansionary policy is a popular strategy for dealing with periods of low growth in the business cycle, but it is not without risks. These hazards include concerns with macroeconomics, microeconomics, and political economy. When to engage in expansionary policy, how much to undertake, and when to stop needs sophisticated analysis and is fraught with significant uncertainty. Excessive expansion can result in negative consequences such as high inflation or an overheated economy.
Other disadvantages include:
#1. Risk of Outdated Analysis
There is a time lag between when a policy decision is made and when it is implemented in the economy. Even for the most seasoned economists, this makes up-to-the-minute analysis practically impossible. Prudent central bankers and legislators must understand when to limit money supply growth or even reverse course and turn to contractionary policy, which entails adopting the opposite measures of expansionary policy, such as hiking interest rates.
#2. Risk of Macroeconomic Distortions
Even in the best of circumstances, expansionary fiscal and monetary policy risk causing microeconomic distortions in the economy. Simple economic models frequently depict the impacts of expansionary policy as neutral to the economy’s structure, as if the money injected into the economy were distributed uniformly and instantly throughout the economy.
In practise, both monetary and fiscal policy work by delivering additional money to specific individuals, businesses, and industries, who subsequently spend and circulate the new money throughout the economy. Rather than uniformly increasing aggregate demand, this means that expansionary policy always includes an effective transfer of purchasing power and wealth from the earlier users of the additional money to the later ones.
#3. Risk of Corruption
Furthermore, an expansionary policy, like any other government policy, is susceptible to information and incentive issues. The allocation of the money put into the economy by expansionary policy can obviously involve political issues. Rent-seeking and principal-agent issues are common whenever big sums of public money are on the table. Expansionary policy, whether fiscal or monetary, entails the allocation of significant sums of public money.
Examples of Expansionary Policy
The response to the 2008 financial crisis, when central banks throughout the world slashed interest rates to near-zero levels and implemented large stimulus spending programmes, is a prime illustration of expansionary policy. This includes the American Recovery and Reinvestment Act and many rounds of quantitative easing by the Federal Reserve of the United States. US officials pumped trillions of dollars into the US economy to boost domestic aggregate demand and shore up the financial system.
The ARRA’s components are a traditional collection 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.
In a more contemporary example, falling oil prices from 2014 to the second quarter of 2016 slowed numerous economies. Canada was particularly heavily hit in the first half of 2016, with the energy industry accounting for about one-third of its total economy. As a result, bank profitability fell, rendering Canadian banks vulnerable to bankruptcy.
To offset the country’s low oil prices, Canada used an expansionary monetary policy by lowering interest rates. The expansionary policy was intended to stimulate domestic economic growth. However, the policy meant that net interest margins for Canadian banks fell, pinching bank earnings.
Expansionary Policy During COVID-19
The COVID-19 pandemic was a more recent and dramatic example of expansionary policy. In reaction to temporary business closures and a standstill in the economy, the Federal Reserve cut interest rates from 1.5%-1.75% to 0%-0.25% in March 2020. Governments appeared to want to make it as simple as possible for individuals and corporations to obtain low-cost financing.
During the epidemic, the IRS granted three Economic Impact Payments as an example of fiscal policy. Taxpayers may get three payments, assuming they do not exceed income thresholds: £1,200 in April 2020, £600 in December 2020, and £1,400 in March 2021. There were also other Child Tax Credit options available.
The Federal Reserve’s open market operations were another example of expansionary policy under COVID-19. The Treasury raised trillions of dollars through issuing Treasury bills, and the Treasury also had a record large amount of operating cash on hand (£1.6 trillion). It also increased its purchases of Treasury securities and other debt instruments to inject capital into the market; the Federal Reserve did not begin to reduce these purchases until 2022.
Expansionary vs. Contractionary Fiscal Policy
Expansionary fiscal policy is utilised more frequently than contractionary fiscal policy. Voters favour both tax cuts and increased benefits, thus, politicians who pursue expansionary policy are typically more popular. State and local governments in the United States are subject to balanced budget requirements, which require them not to spend more than they collect in taxes. This is a good discipline, but it limits lawmakers’ capacity to stimulate economic growth during a recession. They must cut spending when tax revenues are down if they do not have a surplus on hand. Spending cuts exacerbate the recession in this scenario.
Expansionary Monetary Policy
Expansionary monetary policy is when a country’s central bank expands the money supply, and it is more effective than fiscal policy. The Federal Reserve can quickly vote to raise or cut the fed funds rate at its regular Federal Open Market Committee meetings, but the effect may take up to six months to spread across the economy. The Fed can also use contractionary monetary policy to raise interest rates while preventing inflation.
When is Expansionary Fiscal Policy Used?
During a recession (or to avoid a recession), governments often utilise expansionary fiscal policy. When the economy moves from a recession to an expansion, the government adopts a more contractionary fiscal policy.
What Does Expansionary Fiscal Policy Do to Interest Rates?
Expansionary fiscal policy raises interest rates. In practise, the Federal Reserve intervenes to mitigate the effects of expansionary fiscal policy on the interest rate environment.
What Are Some Examples of Expansionary Monetary Policy?
As its major weapon of expansionary monetary policy, the Federal Reserve frequently modifies the Federal funds reserve rate. Increasing the Fed rate shrinks the economy, whereas dropping the Fed rate expands it.
How Does Expansionary Policy Affect Inflation?
Expansionary policy frequently has the unintended consequence of causing (or worsening) inflation. The Federal Reserve is typically forced to choose between combating unemployment and combating inflation; any policies enacted to reduce one usually raise the other. This is because expansionary policy usually means that people have more money. Because of increased product demand, more consumers can afford to buy items at higher costs.
What Monetary Policy Reduces Inflation?
In addition to expansionary policy, the Federal Reserve may implement contractionary policies. These policies are intended to slow the economy, increase the cost of borrowing, and reduce the money supply. Inflation is often slowed by slowing the economy, cutting consumer demand, and slowing corporate expansion, even though unemployment is at risk of rising.
How Does Expansionary Fiscal Policy Increase Aggregate Demand?
Expansionary fiscal policy aims to boost aggregate demand by lowering taxes and increasing government spending. Both provide additional funds to consumers and businesses, allowing them to buy and invest.
How Does Expansionary Fiscal Policy Affect the Aggregate Demand Curve?
Expansionary fiscal policy is when Congress moves to lower tax rates or boost government expenditure, causing the aggregate demand curve to shift to the right. Contractionary fiscal policy is when Congress raises tax rates or reduces government spending, causing aggregate demand to move to the left.
The Bottom Line
Expansionary policy refers to a collection of economic measures implemented by a government or central bank in order to boost economic growth. These initiatives are designed to boost aggregate demand and spending. Although it may accidentally raise the rate of annual inflation, the purpose of expansionary policy is to stimulate the economy during periods of poor development or recession.
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