These policies are used to spur economic activity
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Examples of expansionary fiscal policy include tax cuts and increased government spending. Both of these policies are intended to increase aggregate demand while contributing to deficits or drawing down budget surpluses. Normally, they’re employed during recessions to spur a recovery or amid fears of one.
Classical macroeconomics considers fiscal policy to be an effective strategy for use by the government to counterbalance the natural depression in spending and economic activity that takes place during a recession. As business conditions deteriorate, consumers and businesses cut back on spending and investments. This cutback causes business to deteriorate further and sets off a cycle from which it can be difficult to escape.
Key Takeaways
- Two examples of expansionary fiscal policy are tax cuts and increased government spending.
- Expansionary fiscal policy is used to prevent or end recessions, or to prevent high unemployment.
- The Economic Stimulus Act of 2008 allowed the government to put money directly into consumers’ pockets in the hope of stimulating spending.
- A downside of expansionary fiscal policy tax cuts is that they must be reversed later.
- John Maynard Keynes identified fiscal policy as key to alleviating the negative economic consequences of slowing spending and economic activity.
How Economic Activity Changes During a Recession
During recessions, the purchasing behavior of individuals changes. They must re-evaluate decisions about the types of products they buy. Overall, spending decreases. This reduction in spending and economic activity leads to less revenue for businesses. That, in turn, leads to greater unemployment and an even greater diminishment of spending and economic activity.
During the Great Depression, John Maynard Keynes was the first to identify this self-reinforcing negative cycle in his book, “General Theory of Employment, Interest, and Money.” He identified fiscal policy as a way to smooth out and prevent these tendencies of the business cycle.
| Pros | Cons |
| It can have a rapid impact if implemented correctly. | All the new spending can become a detriment to the economy if it flames inflation. |
| Government spending can create jobs and lessen unemployment. | Tax cuts diminish government revenue, which can result in a growing national debt, erosion of public confidence, and rising interest rates. |
| Tax cuts can put money directly into taxpayers’ pockets. | The tax cuts used to improve economic conditions must be reversed later to restore revenue and to pay down the national debt. |
| Unemployment compensation can quickly get spending moving again. | Government leaders may use expansionary fiscal policy for their own ends (e.g., to build political allegiance) and not for the good of the economy and the people. |
| It can restore confidence that the government can improve economic activity and reduce financial woes. |
How Tax Cuts Help Stimulate Economic Activity
Faced with an economic slowdown, the government may attempt to bridge the reduction in demand by giving a windfall to citizens via a tax cut or an increase in government spending. This can create jobs and alleviate unemployment.
An example of tax cuts as expansionary fiscal policy is the Economic Stimulus Act of 2008, in which the government attempted to boost the economy by sending taxpayers $600 or $1,200 depending on their marital status and number of dependents. The total cost was $152 billion.
Tax cuts are favored by conservatives for effective expansionary fiscal policy because they have less faith in the government and more faith in markets.
Liberals tend to be more confident in the ability of the government to spend judiciously and are more inclined towards government spending, rather than tax cuts, as a means of expansionary fiscal policy.
An example of government spending as expansionary fiscal policy is the American Recovery and Reinvestment Act of 2009. This effort was made in the midst of the Great Recession and totaled $831 billion. Most of this spending targeted infrastructure, education, and extension of unemployment benefits.
How Can Expansionary Fiscal Policy Help the Economy?
A government can stimulate spending by creating jobs and lowering unemployment. Tax cuts can boost spending by quickly putting money into consumers’ hands. All in all, expansionary fiscal policy can restore confidence in the government. It can help people and businesses feel that economic activity will pick up and alleviate their financial discomfort.
What Are the Negative Aspects of Expansionary Fiscal Policy?
All the new spending spurred by expansionary fiscal policy can cause inflation to rise. Also, the tax cuts made to support spending must be reversed at a later time. Moreover, politicians can use expansionary fiscal policy for their political purposes, rather than for the good of the country.
What Are the 3 Types of Fiscal Policy?
The three types of fiscal policy are neutral, expansionary, and contractionary. A neutral policy is one where the government takes no steps to provide economic support because it feels the economy is healthy and stable. An expansionary fiscal policy involves increasing spending or cutting taxes to prevent or end a recession or depression. A contractionary fiscal policy involves cutting spending or raising taxes to slow down unsustainable economic growth.
The Bottom Line
Tax cuts and increased government spending are two well-known forms of expansionary fiscal policy.
They are often used to counteract dips in the economy, such as during recessions. For instance, when market conditions are in a downturn, consumers and businesses might scale back on spending, in turn triggering less economic activity. This cycle can become a negative feedback loop. Expansionary fiscal policy serves as a buffer in such scenarios.
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