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Expansionary Fiscal Policy

Theme 7: Macroeconomics Policies

Topic: Expansionary Fiscal Policy

Relevance: H1 and H2 Economics


Government can introduce demand management policy of expansionary fiscal policy to achieve its macroeconomic goals of economic growth and lower unemployment.

Expansionary fiscal policy could include decreasing tax rates and or increasing government expenditure (G). Government can decrease direct taxes such as personal income tax and corporate tax.

The decrease in personal income tax would result in the increase in household’s disposable income and purchasing power. This increases household’s willingness and ability to purchase goods and services resulting in the increase in consumption expenditure (C).

The decrease in corporate tax, which is the tax on firm’s profits, would result in the increase in post-tax profits. This increases firms’ willingness and ability to expand and attract new firms resulting in an increase in investment expenditure (I). Lower tax rate encourages more investments as the expected rate of return (MEI) increases.

Increase in government expenditure (G) includes the spending on infrastructure building, education, healthcare and defence. This is a form of injection into the economy.

Increase in consumption expenditure (C). investment expenditure (I) and government expenditure (G) would lead to an increase in aggregate demand and the aggregate demand curve to shift right from ADOriginal to ADNew in Figure 1.

Figure 1: Increase in Aggregate Demand

When aggregate demand increases, there will be excess demand in the short run at original price level P0 as aggregate demand is more than aggregate supply. This will lead to unplanned shortage of inventories and hence induce firms to increase their output level in the next period leading to an increase in the real national income via the multiplier effect from YO to YN and inflation as general price level increases from P0 to PN. As real output increases, firms would employ more resources such as labour, resulting in an increase in demand of labour. Increase in demand of labour will lead to a fall in unemployment, especially demand-deficient unemployment.

Therefore, expansionary fiscal policy would result an increase in real national income, decrease in unemployment but also inflation as general price level increased.

Advantages of using Expansionary Fiscal Policy

  • Government expenditure (G) is a component of AD, therefore increase in G will directly affect AD which could lead to shorter time lag as compared to other policies which influence AD indirectly.

  • Fiscal policies increase employment or decreases unemployment.

  • Situation for country with a larger multiplier size as real income will increase more compared to another country with a smaller multiplier.

Disadvantages of using Expansionary Fiscal Policy

  • Increase in AD would result in an increase in GPL or Inflation which will have adverse impact on the economy.

  • Expansionary Fiscal Policy might lead to a less favourable fiscal position for the government as tax revenue decreases and government spending increases. This might lead to budget deficit or fiscal debt which will have adverse impact on the economy.

  • Expansionary Fiscal Policy are unlikely a long term or sustainable policy.

  • Not situation for country with a smaller multiplier size as real income will increase lesser compared to another country with a larger multiplier.

  • Might lead to crowding-out effect as the increase in government expenditure (G) may crowd out firms’ investment expenditure(I) as government might borrow from the banks in order to finance the increase in the G which will compete with the firms for the limited amount of the loanable funds. Crowding-out effect could also occur given the limited amount of resources, for example land, the increase in government utilization of land would cause greater competition for the use of these scarce resources for firms.

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