Expansionary and contractionary
Definition
Fiscal policy: the use of government spending and taxation to influence aggregate demand and the wider economy.
Expansionary fiscal policy
- Expansionary fiscal policy raises government spending or cuts taxes to increase aggregate demand.
- It tends to widen a budget deficit or reduce a surplus.
- It is typically used in a downturn to raise output and reduce unemployment.
Example
- In a recession a government raises infrastructure spending by £40bn, with spending previously £800bn, tax revenue £780bn and GDP £2000bn.
- Higher G shifts AD right, so real output rises and cyclical unemployment falls, though the deficit widens to 3% of GDP.
- Whether the effect lands mainly on output or on the price level depends on how close the economy is to full capacity on LRAS.
Contractionary fiscal policy
- Contractionary fiscal policy cuts government spending or raises taxes to reduce aggregate demand.
- It tends to narrow a budget deficit or build a surplus.
- It is typically used in a boom to curb demand-pull inflation.
Example
- In a boom the government raises the income tax rate from 20% to 25% for a worker earning £30000.
- Disposable income falls by £1500, so consumption and AD shift left, easing demand-pull inflation.
Key Idea
- The stance is defined by the direction of the change, not the level of the budget.
- Cutting a large deficit is contractionary even though the budget is still in deficit.
Choosing the stance
- A government uses expansionary policy when output is below capacity and unemployment is high.
- It uses contractionary policy when the economy is overheating and inflation is rising.
- Both stances work by shifting aggregate demand, which is analysed on an AD/AS diagram.
Exam technique
- State the instrument, its direction, the effect on aggregate demand and the objective it serves.
- For example, higher spending raises AD, so output and employment rise.
- Match expansionary policy to a downturn and contractionary policy to a boom.
Common Mistake
- Do not confuse fiscal policy with monetary policy here.
- Fiscal policy changes spending and taxation, not interest rates.
- Do not judge the stance from whether the budget is in deficit or surplus.
- Judge it from whether spending and taxation are being loosened or tightened.
Self review
- Define fiscal policy.
- State two ways of running expansionary fiscal policy.
- In which phase of the cycle is contractionary policy usually used?
- Why can cutting a deficit still count as contractionary?
