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Fiscal Policy

Expansionary Fiscal Policy

Governments pursue an expansionary fiscal policy to increase aggregate demand (usually via deficit spending) when they want to make the economy grow.

Expansionary fiscal policy is increases in government spending or tax cuts designed to increase aggregate demand and lift the economy out of a recession. An expansionary policy is the most common type of fiscal policy governments pursue. When the economy is in a healthy growth pattern, there is generally no need—or political pressure—for the government to intervene in the economy. The need for government intervention arises in the instance of a recession (a decline in real gross domestic product [GDP] for two consecutive quarters or more) or a depression (extended recession), so most government interventions take the form of measures that will increase spending and reduce taxes to boost aggregate demand. The overall goal of an expansionary policy is to return the economy to a healthy growth rate, the rate at which the economy is expanding, at around 2 percent to 3 percent per year for the United States (this number varies for different countries' economies).

An expansionary policy increases the amount of money available to companies and households in an economy. This is achieved through the two main methods of fiscal policy: increasing government spending and cutting taxes. Increased government spending boosts the economy by increasing aggregate demand, which lowers unemployment (the percentage of the labor force who are looking for work), boosting wages. According to the spending multiplier concept, consumption, as a result of spending, will increase future consumption and additionally increase the GDP. For instance, if the government invests $1 million on an infrastructure project, it is contributing more than $1 million to the economy because the project requires the hiring of workers, who receive income. In turn, their income is spent elsewhere and that money spent becomes another person's income, and so on. The benefit of that project expenditure, then, is multiplied.

Tax cuts work to boost the economy by increasing the amount of money available to households and businesses, encouraging consumer spending and business investment. The focus is generally on cutting income taxes for individuals, but tax cutting is not exclusive to just income taxes. In a developed economy such as the United States, consumer spending accounts for about 70 percent of GDP. As a result, the most commonly used fiscal policy measures in an expansionary policy act directly to stimulate consumer spending.

An expansionary fiscal policy is attractive to policymakers for several reasons. It allows them to react quickly to developing economic crises. In periods of high unemployment, governments can invest directly to hire workers and drive up wages. The best example of this in U.S. history took place during the Great Depression, a period of serious economic downturn in the 1930s. President Franklin D. Roosevelt's administration created the New Deal, which used expansionary policy to create programs and hire workers to try to end the Great Depression. The government can also boost unemployment benefits, which mitigate the effects of high unemployment by putting cash in the hands of the unemployed.
The initial point of equilibrium (where AD1 crosses SRAS) equates to a recessionary gap, in which the initial output quantity (Y1)is less than full-employment GDP. A shift of aggregate demand outward from AD1 to AD2 can be executed by an expansionary fiscal policy. The result of the shift is a new equilibrium output (where AD2 crosses SRAS) and a level of output equal to full employment GDP, which is highlighted by the long-run aggregate supply (LRAS) curve. This new equilibrium point is where AD2, SRAS1, and LRAS intersect. An inflationary increase in price level (P1 to P2) will occur due to this shift, but this increase is relatively small because the economy was previously in a recessionary gap.