Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Consider first the situation in (Figure), which is similar to the U.S. economy during the 2008-2009 recession. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level. During the 2008-2009 Great Recession (which started, actually, in late 2007), the U.S. economy suffered a 3.1% cumulative loss of GDP. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. I. The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. Expansionary fiscal policy used during economic downturns inevitably leads to a budget Suppose the government responds to the downturn by increasing government spending by $250 billion, but keeps tax rates the same. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. During a recession, the total output in an economy usually falls as a result of slowed economic activities. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Procyclical policy does the opposite and is generally seen to be counterproductive, potentially overheating the economy during expansions and further dampening growth during recessions. Figure 2. According to another finding from the study, the welfare effect of expansionary fiscal policy is only positive under circumstances where hysteresis is present, which is to say, during a recession. Figure 30.11 Expansionary Fiscal Policy The original equilibrium (E 0) represents a recession, occurring at a quantity of output (Y 0) below potential GDP. During the 2008-2009 Great Recession (which started, actually, in late 2007), the U.S. economy suffered a 3.1% cumulative loss of GDP. stable, like during a recession, the American people turn the government and demand that they fix whatever problem is occurring. The third task is support of aggregate demand. A decrease in taxation will lead to people having more money and consuming more. As aggregate supply increases, incomes tend to go up. An expansionary discretionary fiscal policy is typically used during a recession. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? The new equilibrium (E1) is an output level of 206 and a price level of 92. Information, Risk, and Insurance, Introduction to Information, Risk, and Insurance, 16.1 The Problem of Imperfect Information and Asymmetric Information, 17.1 How Businesses Raise Financial Capital, 17.2 How Households Supply Financial Capital, 18.1 Voter Participation and Costs of Elections, 18.3 Flaws in the Democratic System of Government, Chapter 19. During a recession, the total output in an economy usually falls as a result of slowed economic activities. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. The original equilibrium (E 0) represents a recession, occurring at a quantity of output (Yr) below potential GDP.However, a shift of aggregate demand from AD 0 to AD 1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of potential GDP. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one. Brookings. After the second quarter of 2001, the U.S. economy has entered into a recession phrase. Expansionary Fiscal Policy. Expansionary fiscal policy can increase output; it can increase the utilization of resources; and in particular, when monetary policy has reduced interest rates to zero, it can meaningfully shift the economy’s trajectory upwards. This fiscal expansion is often financed through borrowed funds that will need to be paid back. An expansionary policy may lead to crowding out. An example of government spending as expansionary fiscal policy is the American Recovery and Reinvestment Act of 2009. Voters like both tax cuts and more benefits, and as a result, politicians that use expansionary policy tend to be more likable. Fiscal policy during the current contraction, recovery, and beyond may take two forms: (1) fiscal policy designed to prevent business failures and sustain the unemployed during the initial pronounced contraction; and (2) fiscal policy used during a traditional recession and recovery aimed at stimulating aggregate The idea is to inject spending into the economy during a recession when no one is spending and reduce spending and collect taxes when the economy is booming. An expansionary discretionary fiscal policy is typically used during a recession. Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. When might it use contractionary fiscal policy? Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? Generally, this stimulates the economy during a recession or downturn. However, a shift of aggregate demand from AD 0 to AD 1 , enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E 1 at the level of potential GDP which the LRAS curve shows. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve. During extensive recession, expansionary fiscal policy may not cause inflation. However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The new equilibrium (E1) is an output level of 206 and a price level of 92. enact expansionary fiscal policy during a recession than to enact restrictive fiscal policy during an economic expansion. Fiscal policy also has become more expansionary. stable, like during a recession, the American people turn the government and demand that they fix whatever problem is occurring. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. Fiscal policy stance during past periods of expansion 63 7 Fiscal policy stance during past periods of expansion Prepared by Maria Grazia Attinasi, Alessandra Anna Palazzo and Beatrice Pierluigi Economic activity in the euro area and in most of its member countries has recovered to pre-crisis levels and is currently expanding. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Expansionary fiscal policies, which are usually implemented during recessions, attempt to increase economic demand. At the equilibrium (E0), a recession occurs and unemployment rises. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP. For example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession… Government can enact changes in fiscal policy by changing taxes and government spending levels in various sectors. What is the difference between expansionary fiscal policy and contractionary fiscal policy? Chicago: University Of Chicago Press, 2013. Principles of Economics by Rice University is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Typically this type of fiscal policy results in increased government spending and/or lower taxes. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Poverty and Economic Inequality, Introduction to Poverty and Economic Inequality, 14.4 Income Inequality: Measurement and Causes, 14.5 Government Policies to Reduce Income Inequality, Chapter 15. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. In 2009, the UK government pursued a degree of expansionary fiscal policy – cutting VAT and allowing the budget deficit to increase to a record peace-time level. 1.1 What Is Economics, and Why Is It Important? This effort was taken on in the midst of the Great Recession … Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer: Alesina, Alberto, and Francesco Giavazzi. Aggregate demand and aggregate supply do not always move neatly together. Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? The choice between whether to use tax or spending tools often has a political tinge. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate. B. aggregate supply curve will shift to the left. The most common fiscal policy actions in a recession are: Advertisement. When an economy is in a recession, expansionary fiscal policy is in order. The use of expansionary fiscal policy during a recession is likely to result in _____. At the equilibrium (E0), a recession occurs and unemployment rises. Second, fiscal policy is an effective aspect of the government’s part of a response to a recession. Again, the AD–AS model does not dictate how this contractionary fiscal policy is to be carried out. Creative Commons Attribution 4.0 International License, Explain how expansionary fiscal policy can shift aggregate demand and influence the economy, Explain how contractionary fiscal policy can shift aggregate demand and influence the economy. The idea is to inject spending into the economy during a recession when no one is spending and reduce spending and collect taxes when the economy is booming. Public choice analysis indicates that it will be politically more attractive to. The choice between whether to use tax or spending tools often has a political tinge. The government can handle the economy in a recessionary period in one of two ways: expansionary fiscal policy or expansionary monetary policy… Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Government Budgets and Fiscal Policy, Introduction to Government Budgets and Fiscal Policy, 30.3 Federal Deficits and the National Debt, 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation, 30.6 Practical Problems with Discretionary Fiscal Policy, Chapter 31. “The Role of Fiscal Stimulus in the Ongoing Recovery.” Last modified July 6, 2012. http://www.brookings.edu/blogs/jobs/posts/2012/07/06-jobs-greenstone-looney. This is because, during a recession, there is usually very low economic activities which translate to low national income, low employment rate, … We did get a fiscal stimulus package shortly after Obama took office, and it helped. The International Trade and Capital Flows, Introduction to the International Trade and Capital Flows, 23.2 Trade Balances in Historical and International Context, 23.3 Trade Balances and Flows of Financial Capital, 23.4 The National Saving and Investment Identity, 23.5 The Pros and Cons of Trade Deficits and Surpluses, 23.6 The Difference between Level of Trade and the Trade Balance, Chapter 24. As these occur, the government may choose to use fiscal policy to address the difference. Principles of Economics 2e by Rice University is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Expansionary monetary policy deters the contractionary phase of the business cycle. In addition, the price level would rise back to the level P1 associated with potential GDP. will lead to a slower recovery than would have been the case if government borrowing had been more restrained. There are two types of fiscal policy: Expansionary and Contractionary. Macroeconomic Policy Around the World, Introduction to Macroeconomic Policy around the World, 32.1 The Diversity of Countries and Economies across the World, 32.2 Improving Countries’ Standards of Living, 32.3 Causes of Unemployment around the World, 32.4 Causes of Inflation in Various Countries and Regions, 33.2 What Happens When a Country Has an Absolute Advantage in All Goods, 33.3 Intra-industry Trade between Similar Economies, 33.4 The Benefits of Reducing Barriers to International Trade, Chapter 34. What is the main reason for employing expansionary fiscal policy during a recession? Greenstone, Michael, and Adam Looney. Use the term expansionary fiscal policy when the government is spending more than it is receiving. Second, fiscal policy is an effective aspect of the government’s part of a response to a recession. But it is difficult for policymakers to catch this in time. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level. Monopoly and Antitrust Policy, Introduction to Monopoly and Antitrust Policy, Chapter 12. Expansionary fiscal policy is used to stimulate aggregate demand and boost the rate of economic growth. Tax cuts for businesses or for individuals - This gives people and corporations more money, which may make them more likely to buy things, which increases demand. Expansionary fiscal policy will be used in a recession or a period of a negative output gap. Through lowering of interest rates, which is a characteristic of expansionary monetary policy, the size of the money supply increases. Think about what causes shifts in aggregate demand over time. Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. 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