Expansionary Fiscal Policy

This type of policy is exercised in times of recession.

The government can do one of the following:

• Increase government spending

• Reduce taxes

• Do a combination of both

Increased Government Spending

When the government spends in excess of tax revenues, the government creates a budget deficit

An increase in government spending directly causes an increase in the aggregate demand to the right (AD1 to AD2).  The multiplier process magnifies the initial change in spending, and therefore, the aggregate demand further increases to AD3.

Tax Reductions

The same result above can also be achieved by decreasing taxes.

A larger tax cut than an increase in government spending is necessary to achieve the same amount of rightward shift.

For example, if the MPC is 0.75, taxes must fall by $6.67 billion to have an increase of $5 billion in consumption.

How does the government finance a Deficit?

• The government can enter the money market and compete with private borrowers for funds

• The government can create more money.  This is a more expansionary way to finance a deficit.

Criticisms and Complications of Fiscal Policy

Timing Problems

• Recognition Lag - it takes time for economists to recognize a recession is occurring

• Administrative Lag - it takes time for the government to act

• Operational Lag - it takes time for the changes to take effect

Crowding Out Effect

This occurs under an expansionary fiscal policy.  If the government enters the money market to finance the deficit, the government will crowd out investors.  The increased demand for money raises interest rates.  Because investment is inversely related to interest rates, investment will decrease.  This will offset the effects of an expansionary fiscal policy - the aggregate demand curve moves slightly to the left.

Net Export Effect

This occurs under an expansionary fiscal policy.  If the government enters the money market to finance the deficit, interest rates will rise.  The higher interest rate causes the dollar to appreciate.  Therefore, net exports decline, and aggregate demand decreases, which offsets the effects of expansionary fiscal policy.

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