Grade 11

Advanced

7 min

Lesson 4 of 12

Expansionary vs. Contractionary Fiscal Policy

Not Started

Analyzing when and why the government chooses to stimulate or cool down the economy.

Imagine the economy is a car: sometimes it is stalled on a hill, and other times it is speeding dangerously toward a cliff. How does the government use the 'gas pedal' of spending and the 'brakes' of taxes to keep us on the road?

Learning Objectives

1.Analyze the impact of expansionary fiscal policy on the Aggregate Demand (AD) curve.
2.Describe the conditions under which contractionary fiscal policy is used to combat inflation.
3.Predict the short-term effects of fiscal shifts on real GDP and the price level.

The Gas Pedal: Expansionary Fiscal Policy

When an economy faces a recessionary gap, it operates below its potential output, leading to high unemployment. To fix this, the government employs Expansionary Fiscal Policy. The goal is to increase Aggregate Demand (AD), shifting the curve to the right. This is achieved through two primary levers: increasing government spending (

G \uparrow

) or decreasing taxes (

T \downarrow

). A tax cut increases disposable income, which boosts consumer spending (

C

). The total effect on AD is defined by the formula:

AD = C + I + G + (X - M)

By increasing

G

C

, the government pushes the economy toward full employment, raising both real GDP and the price level.

1. The economy is in a recession with a GDP gap of $100$ billion. 2. The government decides to spend $20$ billion on new infrastructure (highways and bridges). 3. This $G$ increase directly shifts the $AD$ curve to the right. 4. Workers hired for these projects spend their new wages, further increasing $C$ and shifting $AD$ even more.

Quick Check

If the government wants to close a recessionary gap, should they increase or decrease the tax rate?

Think about which action puts more money into the hands of consumers.

Answer

Decrease the tax rate to increase disposable income and consumption.

The Brakes: Contractionary Fiscal Policy

When the economy grows too fast, it creates an inflationary gap. Here, demand outstrips supply, causing prices to skyrocket. To 'cool down' the economy, the government uses Contractionary Fiscal Policy. This involves decreasing government spending ( $G \downarrow$ ) or increasing taxes ( $T \uparrow$ ). These actions reduce the amount of money circulating, shifting the AD curve to the left. While this may slightly increase unemployment, its primary purpose is to stabilize the price level and maintain the purchasing power of the currency. It is the economic equivalent of tapping the brakes to avoid a crash.

1. Inflation is rising at $8\%$ per year, well above the $2\%$ target. 2. The government implements a 'surplus budget' by cutting department budgets by $50$ billion. 3. Simultaneously, they raise corporate tax rates. 4. Result: $AD$ shifts left, the price level ( $P$ ) stabilizes, and the economy returns to its long-run equilibrium.

Quick Check

What is the primary macroeconomic goal of contractionary fiscal policy?

Focus on the 'price level' rather than 'growth'.

Answer

To reduce inflation by cooling down an overheating economy.

The Multiplier Effect and Crowding Out

Fiscal policy is powerful because of the Spending Multiplier. A single dollar of government spending can result in more than a dollar of economic growth because that money is re-spent by others. The multiplier is calculated as:

M = \frac{1}{1 - MPC}

where

MPC

is the Marginal Propensity to Consume. However, there is a catch: Crowding Out. If the government borrows heavily to fund spending, it increases the demand for loanable funds, which can drive up interest rates. Higher interest rates make it expensive for private businesses to borrow, potentially 'crowding out' private investment (

I \downarrow

1. Suppose the $MPC$ is $0.80$ . The multiplier is $M = \frac{1}{1 - 0.80} = 5$ . 2. If the government increases spending by $10$ billion, the theoretical increase in $AD$ is $50$ billion ( $10 \times 5$ ). 3. However, if this borrowing causes interest rates to rise from $3\%$ to $5\%$ , private firms might cancel $15$ billion in planned factory expansions. 4. The net shift in $AD$ would be the initial boost minus the 'crowded out' private investment.

Key Takeaways

1Expansionary policy ( $G \uparrow, T \downarrow$ ) fights recessions by shifting AD right.
2Contractionary policy ( $G \downarrow, T \uparrow$ ) fights inflation by shifting AD left.
3The Spending Multiplier ( $1 / (1-MPC)$ ) amplifies the impact of fiscal changes.
4Crowding Out occurs when government borrowing raises interest rates, reducing private investment.

Quick Check

Multiple Choice

Which combination of actions represents a purely expansionary fiscal policy?

Multiple Choice

If the MPC is $0.75$ , what is the spending multiplier?

True/False

Crowding out is a potential side effect of expansionary fiscal policy that can reduce its overall effectiveness.

What's Next?

Review Tomorrow

In 24 hours, try to sketch an AD/AS graph showing how expansionary policy moves the equilibrium point.

Practice Activity

Look up a recent news article about a government 'stimulus package' or 'austerity measure' and identify if it is expansionary or contractionary.

Browse

Browse

Expansionary vs. Contractionary Fiscal Policy

Learning Objectives

The Gas Pedal: Expansionary Fiscal Policy

The Brakes: Contractionary Fiscal Policy

The Multiplier Effect and Crowding Out

Key Takeaways

Quick Check

What's Next?

Expansionary vs. Contractionary Fiscal Policy

Learning Objectives

The Gas Pedal: Expansionary Fiscal Policy

The Brakes: Contractionary Fiscal Policy

The Multiplier Effect and Crowding Out

Key Takeaways

Quick Check

What's Next?