Expansionary and Contractionary Fiscal Policy

Expansionary and Contractionary Fiscal Policy Examples

Let's take a look at some examples of expansionary and contractionary fiscal policies! Remember, the primary aim of an expansionary fiscal policy is to stimulate aggregate demand, whilst of contractionary fiscal policy - to lower aggregate demand.

Expansionary fiscal policies examples

Governments can reduce the tax rate to stimulate consumption and investment in the economy. As individual disposable income increases due to a reduction in taxes, more consumer spending would go towards purchasing goods and services. As the tax rate for businesses decreases, they will be willing to undertake more investments, thereby creating more economic growth.

Governments can increase their spending to increase the aggregate demand in the economy.

Governments can increase transfers by increasing availability of social welfare benefits to the public in order to increase household income and spending by extension.

Contractionary fiscal policies examples

Governments can increase the tax rate to reduce consumption and investment in the economy. As individual disposable income decreases due to an increase in taxes, less consumer spending would go towards purchasing goods and services. As the tax rate for businesses increases, they will be willing to undertake fewer investments, thereby slowing down economic growth.

Governments can decrease their spending to decrease the aggregate demand in the economy.

Governments can decrease transfers by reducing availability of social welfare benefits to the public in order to reduce household income and spending by extension.

Difference between Expansionary Fiscal Policy and Contractionary Fiscal Policy

The figures below demonstrate the difference between the expansionary fiscal policy and contractionary fiscal policy.

Fig. 1 - Expansionary Fiscal Policy

In Figure 1, the economy is in a negative output gap demonstrated by the (Y1, P1) coordinates, and output is below the potential output. Through the implementation of an expansionary fiscal policy the aggregate demand shifts from AD1 to AD2. The output is now at a new equilibrium at Y2 - closer to the potential output. This policy would result in consumer disposable income increasing and by extension increasing expenditure, investment and employment.

Fig. 2 - Contractionary fiscal policy

In Figure 2, the economy is at the peak of the business cycle or, in other words, experiencing a boom. It is currently at (Y1, P1) coordinates and actual output is above potential output. Through the implementation of a contractionary fiscal policy, the aggregate demand shifts from AD1 to AD2. The new level of output is at Y2 where it is equal to potential output. This policy would result in consumer disposable income decreasing, resulting in a decrease in expenditure, investment, employment and inflation.

The key difference between the expansionary fiscal policy and the contractionary fiscal policy is that the former is used to expand aggregate demand and close a negative output gap, whereas the latter is used to shrink aggregate demand and close a positive output gap.

Compare and Contrast Expansionary and Contractionary Fiscal Policy

The tables below describe the similarities and differences of the expansionary and contractionary fiscal policies.

Table 1. Expansionary & contractionary fiscal policy similarities - StudySmarter Originals

Table 2. Expansionary & contractionary fiscal policy differences, StudySmarter Originals

Expansionary and Contractionary Fiscal and Monetary Policy

Another tool used to influence the economy besides expansionary and contractionary fiscal policy is monetary policy. These two types of policies can be used hand-in-hand to stabilize an economy that is either suffering from a recession or experiencing a boom.Monetary policy is the efforts of the central bank of a nation to stabilize the economy through influencing the money supply and influencing credit through interest rates.

The monetary policy is implemented through the central bank of a nation. Monetary policy in the U.S. is controlled by the Federal Reserve, also known as the Fed. The Fed has the capacity to act faster than the government to take action when the economy is either facing a recession or experiencing a boom. Given this, there are two types of monetary policy, just like fiscal policy: expansionary and contractionary monetary policy.

Expansionary monetary policy is implemented by the Fed when the economy is facing a downturn or is in a recession. The Fed will reduce interest rates to increase credit and will increase the money supply in the economy, thereby allowing expenditure and investment to increase. This will drive the economy towards economic growth.

Contractionary monetary policy is implemented by the Fed when the economy is facing an increasing amount of inflation due to a boom in the economy. The Fed will increase the interest rate to reduce credit and will reduce money supply in the economy in order to slowdown expenditure and prices. This will drive the economy towards stabilization and will help decrease inflation.