What is an Expansionary Fiscal Policy?

//What is an Expansionary Fiscal Policy?
What is an Expansionary Fiscal Policy? 2017-10-04T07:58:17+00:00

Definition: Expansionary fiscal policy is a macroeconomic concept that seeks to encourage economic growth by increasing the money supply. In other words, it’s a way to stimulate the economy by making money more available to businesses and consumers in hopes that they will spend more. This strategy typically includes tax reduction and/or increased public spending to anticipate recession and increase income balance.

What Does Expansionary Fiscal Policy Mean?

What is the definition of expansionary fiscal policy? Lowering taxes will increase disposable income for average consumers. Thus, they will have more money to spend and will tend to increase consumption. Higher levels of consumption generally leads to a higher GDP. In addition, a lower taxation enables businesses to seek investment opportunities and investor confidence rises, thereby boosting profitability and the private investment component of the GDP. Through tax cuts, the government attempts to prompt consumers and businesses to spend more money, invest more, and revive the economy. At the same time, increased government spending can create short-term jobs, lowers unemployment, increases disposable income, thereby causing a rise in consumption and in GDP.

Alternatively, the government may increase Social Security, unemployment, and low-income welfare benefits in an effort to boost disposable income and increase consumer spending.

The Federal Reserve also plays a role in this strategy by adjusting interest rates, purchasing treasury bills on the open market, and increasing the production of new money.

Let’s look at an example.

Example

Bruce is an economic adviser working closely with the U.S congress to develop suitable fiscal policies for several U.S. states. Florida has 2% inflation, 6% unemployment, 1% GDP growth rate and 5% budget surplus. Illinois has 8% inflation, 1% unemployment, 5% GDP growth rate and 3% budget surplus. In which state should an expansionary fiscal policy be applied?

The answer is that an expansionary policy should be applied to Florida. Why? Because Florida has low inflation, high unemployment, low GDP growth and high budget surplus. This suggests that Florida is dealing with recessionary pressures. Therefore, an expansionary fiscal policy with tax cuts and increased government spending will depress the budget surplus, lower the unemployment rate, and increase GDP growth rate and inflation.

Illinois has high inflation, low unemployment rate, high GDP growth rate and low budget surplus, suggesting inflationary pressures. Therefore, this policy is not recommended, as it would increase inflation further.

Economists have to be careful when applying this concept because its success can only be measured by lagging indicators that aren’t appeared some time after application. Thus, it’s difficult to know when to stop this policy. If it goes for too long, inflation and debt will increase.

Examples in The News

“While the Fed signaled that it would likely respond to expansionary fiscal policies with a faster pace of rate hikes, the Fed believes it is too early to embed this into its baseline.” – NY Times

Summary Definition

Define Expansionary Policy: Expansionary monetary policy means action by a central bank to make currency more available to the economy in an effort to spur growth.