Expansionary Fiscal Policy
Expansionary fiscal policy is a form of fiscal policy in which a government increases public spending or reduces taxation—or both—in order to stimulate aggregate demand, boost economic growth, and reduce unemployment. It is typically used to counter a recession or a period of weak economic activity.[1]
Definition
Expansionary fiscal policy seeks to increase the level of economic activity by injecting demand into the economy. It is the opposite of contractionary fiscal policy, which seeks to reduce demand. The policy is often summarised by the formula for aggregate demand, AD = C + I + G + (X − M), in which an increase in government spending (G) or a reduction in taxes (which raises consumption, C) increases total demand.[1]
Instruments
| Instrument | Mechanism |
|---|---|
| Increased government spending | Directly raises aggregate demand through public investment and services. |
| Tax cuts | Raises disposable income, increasing consumption and investment. |
| Increased transfer payments | Raises incomes of recipients, who tend to spend a high share of additional income. |
Effects
Expansionary fiscal policy can raise output and employment, particularly when the economy has spare capacity and interest rates are low. However, it can also have drawbacks:
- It may widen the fiscal deficit and increase national debt.
- It may cause crowding out, in which government borrowing raises interest rates and reduces private investment.
- If the economy is already near full capacity, it may mainly raise inflation rather than output.
- It may take time to implement, so that its effects arrive after the need has passed.
The multiplier effect determines the eventual impact of an initial change in spending or taxes on total output.[1]