Expansionary and Contractionary Fiscal Policy

Are you living in an economy that is facing a recession or is crippled by inflation? Ever wonder what governments are really doing to restore an economy that is experiencing a recession? Or an economy crippled by inflation? Likewise, are governments the only entities who have sole control in restoring stability in an economy? Expansionary and contractionary fiscal policies are the answer to all our problems! Well, maybe not all our problems, but these macroeconomic tools used by our leaders and also central banks, can definitely be the solution to changing the direction of an economy. Ready to learn about the difference of expansionary and contractionary fiscal policies and more? Then keep scrolling!

Expansionary and Contractionary Fiscal Policy Definition

It is essential to understand what fiscal policy is before discussing expansionary and contractionary fiscal policies.

Fiscal policy is the manipulation of government expenditure and/or taxation to alter the level of aggregate demand in the economy. Fiscal policy is used by the government to manage certain macroeconomic conditions. Depending on the conditions, these policies include either increasing or decreasing taxes and increasing or decreasing government spending. With the use of fiscal policy the government aims to achieve their intended goal of managing the direction of the economy. Implementation of these policies results in a change in the aggregate demand and the corresponding parameters such as aggregate output, investment and employment.

The goal of expansionary fiscal policy is to reduce deflation and unemployment and to increase economic growth. Implementation of expansionary fiscal policies often results in the government incurring deficits as they are spending more than they are accumulating through tax revenue. Governments implement expansionary fiscal policy to pull an economy out of a recession and to close the negative output gap.

The goal of contractionary fiscal policy is to reduce inflation, achieve steady economic growth and sustain the natural rate of unemployment - equilibrium level of unemployment resulting from frictional and structural unemployment. Governments often use contractionary fiscal policy to reduce their budget deficits as they are spending less and accumulating more in tax revenue during those periods. Governments implement contractionary fiscal policies to slow down the economy before it reaches the peak turning point in the business cycle to close the positive output gap.

Expansionary and Contractionary Fiscal Policy Examples

Let's take a look at some examples of expansionary and contractionary fiscal policies! Remember, the primary aim of an expansionary fiscal policy is to stimulate aggregate demand, whilst of contractionary fiscal policy - to lower aggregate demand.

Expansionary fiscal policies examples

Governments can reduce the tax rate to stimulate consumption and investment in the economy. As individual disposable income increases due to a reduction in taxes, more consumer spending would go towards purchasing goods and services. As the tax rate for businesses decreases, they will be willing to undertake more investments, thereby creating more economic growth.

Governments can increase their spending to increase the aggregate demand in the economy.

Governments can increase transfers by increasing availability of social welfare benefits to the public in order to increase household income and spending by extension.

Contractionary fiscal policies examples

Governments can increase the tax rate to reduce consumption and investment in the economy. As individual disposable income decreases due to an increase in taxes, less consumer spending would go towards purchasing goods and services. As the tax rate for businesses increases, they will be willing to undertake fewer investments, thereby slowing down economic growth.

Governments can decrease their spending to decrease the aggregate demand in the economy.

Governments can decrease transfers by reducing availability of social welfare benefits to the public in order to reduce household income and spending by extension.

Difference between Expansionary Fiscal Policy and Contractionary Fiscal Policy

The figures below demonstrate the difference between the expansionary fiscal policy and contractionary fiscal policy.

Fig. 1 - Expansionary Fiscal Policy

In Figure 1, the economy is in a negative output gap demonstrated by the (Y1, P1) coordinates, and output is below the potential output. Through the implementation of an expansionary fiscal policy the aggregate demand shifts from AD1 to AD2. The output is now at a new equilibrium at Y2 - closer to the potential output. This policy would result in consumer disposable income increasing and by extension increasing expenditure, investment and employment.

Fig. 2 - Contractionary fiscal policy

In Figure 2, the economy is at the peak of the business cycle or, in other words, experiencing a boom. It is currently at (Y1, P1) coordinates and actual output is above potential output. Through the implementation of a contractionary fiscal policy, the aggregate demand shifts from AD1 to AD2. The new level of output is at Y2 where it is equal to potential output. This policy would result in consumer disposable income decreasing, resulting in a decrease in expenditure, investment, employment and inflation.

The key difference between the expansionary fiscal policy and the contractionary fiscal policy is that the former is used to expand aggregate demand and close a negative output gap, whereas the latter is used to shrink aggregate demand and close a positive output gap.

Compare and Contrast Expansionary and Contractionary Fiscal Policy

The tables below describe the similarities and differences of the expansionary and contractionary fiscal policies.

Table 1. Expansionary & contractionary fiscal policy similarities - StudySmarter Originals

Table 2. Expansionary & contractionary fiscal policy differences, StudySmarter Originals

Expansionary and Contractionary Fiscal and Monetary Policy

Another tool used to influence the economy besides expansionary and contractionary fiscal policy is monetary policy. These two types of policies can be used hand-in-hand to stabilize an economy that is either suffering from a recession or experiencing a boom.Monetary policy is the efforts of the central bank of a nation to stabilize the economy through influencing the money supply and influencing credit through interest rates.

The monetary policy is implemented through the central bank of a nation. Monetary policy in the U.S. is controlled by the Federal Reserve, also known as the Fed. The Fed has the capacity to act faster than the government to take action when the economy is either facing a recession or experiencing a boom. Given this, there are two types of monetary policy, just like fiscal policy: expansionary and contractionary monetary policy.

Expansionary monetary policy is implemented by the Fed when the economy is facing a downturn or is in a recession. The Fed will reduce interest rates to increase credit and will increase the money supply in the economy, thereby allowing expenditure and investment to increase. This will drive the economy towards economic growth.

Contractionary monetary policy is implemented by the Fed when the economy is facing an increasing amount of inflation due to a boom in the economy. The Fed will increase the interest rate to reduce credit and will reduce money supply in the economy in order to slowdown expenditure and prices. This will drive the economy towards stabilization and will help decrease inflation.