Expansionary Fiscal Policy

Expansionary fiscal policy refers to government strategies aimed at stimulating economic growth, especially during periods of recession or high unemployment. By increasing government spending or cutting taxes, this policy seeks to boost the overall money supply available to the public, thereby encouraging consumer spending and investment. For instance, a government might invest in infrastructure projects or reduce tax burdens on businesses to foster job creation. While expansionary fiscal policy can effectively address economic downturns, it is not without risks, such as exacerbating budget deficits and increasing national debt.

Historically, the concept gained traction through the economic theories of John Maynard Keynes, who argued that government intervention is vital for maintaining macroeconomic stability. Examples of fiscal policy in action include the Economic Stimulus Act and the American Recovery and Reinvestment Act during the Great Recession, both designed to revive economic activity. However, the balance between spending and revenue is crucial; excessive reliance on fiscal measures can lead to inflation and asset bubbles. Ultimately, while expansionary fiscal policy can provide short-term relief, its long-term implications require careful consideration to avoid detrimental economic consequences.

Published in: 2021

By: McBroom, Mandy M., MPH

Subject Terms

Expansionary Fiscal Policy

Abstract

A government’s expansionary policy seeks to address areas of the economy that are significantly underperforming. Fiscal policy, one form of expansionary policy, is used to treat economic issues with a targeted approach. Fiscal policy aims to increase the amount of money in the pockets of the public by making adjustments to the national purse. To address high rates of unemployment, for example, a government may allow employers to pay lower taxes in order to stimulate investment—and therefore the need for more workers—in various sectors; or the government may increase spending on highway construction to provide jobs for special projects.

Overview

Economic periods of low growth can lead to several negative trends, such as layoffs and contraction of benefits, which can worsen the problem. When unemployment is high there is less spending and this leads to more economic strain. The government has several well-vetted financial tools that can help address the problem. Which tool to use depends on whether specific areas in the economy need attention or else the problem is more diffuse. One of the most commonly used expansionary financial tools is fiscal policy. Fiscal policy is used when there are targeted areas of the economy that need to be addressed and the desired solution is to either spur economic growth and reduce unemployment or curb overgrowth. This can be accomplished through increasing the money supply, boosting government spending, and/or (most commonly), cutting taxes. The main idea is to increase the amount of money available to all people, which will in turn increase spending or investments. When spending increases, employers respond by creating more jobs and offering or improving benefits to employees. This approach is generally successful in averting an impending or developing recession.

Historically, fiscal policy was formed as a part of John Maynard Keynes’s economic theories, which suggested that governments can impact macroeconomic productivity through increasing or decreasing taxes or public spending. Prior to World War II, governments used laissez-faire economics, which prohibited governments from intervening when inflation became a significant issue. It was believed that a “natural order” applied to economics, and the less government involvement in the economy, the better. However, this philosophy did not prove advantageous during World War II when the price of goods and monetary value were decreased because of deflation. Deflation usually occurs when the economy is fixed—that is, there is a decrease in demand and an increase in productivity. Deflation will often follow expansionary fiscal or monetary policies have been in effect for long periods.

In response to the profound negative effects of deflation resulting from laissez-faire economics, Keynes posited his general theory of employment, interest, and money—that increasing (or decreasing, as the case may be) taxes and public spending would result in boosting employment and sustaining monetary value. Keynes’s theory was first tested by President Franklin D. Roosevelt when he implemented the New Deal. Initially, fiscal policy had limited success. The difficulty was partly due to inexperience with the policy and partly because businesses were so negatively affected by the Great Depression. Fiscal policy has been implemented several times by U.S. administrations, including the Obama and Trump administrations.

It is rare that fiscal policy is used in isolation. Rather, it is often combined with monetary policy, which involves measures implemented by central banks (i.e., Federal Reserve) to manage interest rates and overall money supply in an economy. Actions taken using monetary policy have a more diffuse effect on the economy, whereas fiscal policy has a more targeted effect. Of the two, monetary policy is used more frequently. In the United States, both monetary and fiscal policy are managed by the executive and legislative branches. As a side note, depending upon the nature of the financial issues, tax cuts are generally viewed more favorably by conservative policy makers, whereas monetary policy is preferred by liberal policy makers.

Fiscal policy is considered to have more immediate effects than monetary policy; however, when an economy is saturated, an ongoing fiscal policy can prompt inflation. This is undesirable because inflation reduces the value of money—thereby shrinking consumer buying power and reducing the profit margins for companies. In some instances, inflated costs cannot be transferred to the customer, in which case layoffs may ensue to relieve the pressure. Another potentially negative effect of fiscal policy is that it can create asset bubbles. Asset bubbles are when the value of an asset becomes over-inflated. This can happen in a short period of time. The housing bubble that occurred in tandem with the Great Recession is a classic example of an asset bubble.

When fiscal policy is properly applied to an economic situation, a balance between public spending and tax rates must be achieved. If the balance is disturbed, such as infusing too much money back into the economy, inflation can be the result. The reason this happens is because consumer demand increases when the economy is stimulated, which can cause the value of money to decline.

Applications

In 2008, through the Economic Stimulus Act, an attempt was made to boost the economy by giving citizens between $600 and $1,200, based on marital status or dependents. The recession was initiated through high oil and food prices, as well as a credit crisis. This act was one of several attempts to quell the recession. Another fiscal policy enacted during the Great Recession was the American Recovery and Reinvestment Act. This measure was implemented in response to sluggish investments in the private sector in 2008–2009. The majority of spending called for in this act targeted infrastructure, education, and the prolonging of unemployment benefits. During this time the central banks used two tools of monetary policy: interest rates were lowered to near zero and quantitative easing was cautiously implemented. Quantitative easing is a measure taken by central banks to lower the cost of money by increasing the supply of money. This strategy is aimed at making it easier to borrow. The total cost for the Obama administration’s stimulus package was $787 billion. This was the largest stimulus package issued since World War II. One criticism of the act was that it helped curb unemployment but was unable to stimulate the gross domestic product (GDP).

One of the dangers of fiscal policy is an increase in the nation’s budget deficit, with spending exceeding revenues, and accumulated national debt. When the American Recovery and Reinvestment Act was enacted, the national debt was approximately $10.63 trillion. By the end of Obama’s second term in 2016, the national debt was $19.5 trillion. Though the Great Recession ended in 2009, economic recovery took years of modest improvement, and the election of Republican Donald Trump in 2016 was widely seen as an expression of frustration with the slow-but-steady progress of the Obama policies. President Trump’s steep tax cuts allowed companies to retain a greater share of profits, but the national debt increased to $21.6 trillion in 2018. The GDP in the third quarter of 2018 was $20.66 trillion.

Issues

Though fiscal policy has the power to reverse a recession and increase employment, there are issues with the use of fiscal policy. Spending that exceeds revenues will always result in a budget deficit, and regular annual deficits result in an expanding national debt. Overuse of fiscal policy, either through increased spending without revenue increases or reduced taxes without program cuts, will exacerbate the national debt. In the United States, it is possible that with the amount of deficit spending that has occurred in the twenty-first century, a new condition is emerging that a simple turn to fiscal and/or monetary policy may not be sufficient to relieve. The tax cuts that were part of the Trump stimulus package included high-income and corporate tax cuts that provided a clear benefit to wealthy individuals, but tax cuts aimed at middle- and working-class taxpayers were modest or negligible by comparison and contained expiration dates. In the first year of the stimulus’s implementation, many regions felt the stimulus did not reach far enough, and despite the corporate tax cuts, companies continued to move operations to cheaper overseas labor markets or otherwise reduce the cost of labor. These regions are predicted to be slower to recover when the next recession hits. Contraction fiscal policy would include decreasing government spending slightly but not to the point of upsetting the balance. Many economists are worried that this will instigate a rather severe austerity response.

Even though cutting taxes and increasing government spending can work to infuse the economy for the short term, there are significant cons to using fiscal policy. The main issue is that government spending has resulted in a marked increase in the deficit. As long as the economy relies too much on consumer spending, the deficit will continue to grow. This would result in a lower economic growth overall, but would increase the savings ratio and encourage long-term investment.

Terms & Concepts

Affordable Care Act: Also known as “Obamacare”; a federal statute enacted by the U.S. Congress in 2010 that sought to make health care more affordable for taxpayers who did not have access to health care through their employers or provide an alternative source of health care. It also sought to increase competition of market health insurance, lowering overall costs, while increasing quality of health care.

American Taxpayer Relief Act: A tax relief reform that attempted to address the expiration of specific aspects of the Economic Growth and Tax Relief Reconciliation Act and Jobs and Growth Tax Relief Reconciliation Act of 2003. It also targeted budget sequestration items under the Budget Control Act of 2011. It mainly locked in the lower rate of the tax cuts passed under George W. Bush and higher tax rate for higher income brackets.

Budget Control Act: A federal statute signed into law by President Obama and the U.S. Congress in 2011. The main focus of the legislation was to increase the debt ceiling, reduce deficit (by reducing spending) and balance the budget. It asked for $917 billion in cuts over ten years without increasing taxes.

Budget Deficit: Annual budgetary shortage that results from overspending and serves as an indicator of financial health.

Deficit Spending: Government spending that occurs when expenditures exceed revenues. This type of spending results in an increase in the national debt.

Deflation: An overall decline in prices for goods and services that is the result of the inflation rate dropping below zero percent. Deflation is a natural occurrence when the economy is fixed, such as during austere conditions.

Federal Reserve: The central banking system of the United States. It was created in 1913 through the passing of the Federal Reserve Act after the panic of 1907, which was a financial crisis that spanned three weeks, when the New York Stock exchange fell nearly 50 percent from the previous year’s peak. The roles and responsibilities of the Federal Reserve increased after the Great Depression.

Inflation: The increase in the average price level of certain goods that occurs over a period of time. Inflation usually results when fiscal policies are applied for too long or overgrowth occurs while demand does not increase.

National Debt: The total debt accumulated by a national government; governments borrow to close the gap between expenditures and revenues. The United States borrows by issuing Treasury securities, which are purchased by investors or held by intragovernmental agencies such as the Social Security Trust Fund.

Quantitative Easing: A monetary policy measure taken by central banks to increase supply of money to lower the cost of money. It is usually employed when interest rates approach zero. It is used to help ensure that inflation does not fall below the targeted level.

Recession: A reduction in economic activity that lasts longer than a typical fiscal variation. Recessions have the effect of causing industries to contract, resulting in layoffs, business closures, and hiring freezes. It is usually the result of a widespread decrease in spending (adverse demand shock). It can be caused by a financial crisis, lack of supply, trade shock, or economic bubble bursting. The response is typically to increase monetary supply, lower taxes, and increase government spending.

Bibliography

Brown, B. (2015). A global monetary plague: Asset price inflation and federal reserve quantitative easing. New York, NY: Palgrave Macmillan.

Cashin, D., Lenney, J., Lutz, B., & Peterman, W. (2017). Fiscal policy and aggregate demand in the U.S. before, during, and following the Great Recession. Working Papers—U.S. Federal Reserve Board’s Finance & Economic Discussion Series. (p. 1–46). Retrieved December 13, 2018 from EBSCO Online Database Business Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=123900436&site=ehost-live

Duca, J. V. (2017). The Great Depression versus the Great Recession in the U.S.: How fiscal, monetary, and financial policies compare. Journal of Economic Dynamics & Control, 81, 50–64. Retrieved December 13, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124355244&site=ehost-live

Fleckenstein, M., Longstaff, F.A., & Lustig, H. (2017). Deflation risk. Review of Financial Studies, 30(8), 2719–2760. Retrieved December 16, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124226463&site=ehost-live

Haltom, R., Weinberg, J.A. (2015). Unsustainable Fiscal Policy: Implications for Monetary Policy. Economic Quarterly, 101(2), 151–167. Retrieved December 13, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=113882703&site=ehost-live

Przybylska-Mazur, A. (2018). Type of government deficit in respect of fiscal decision-making. Financial Sciences, 23(2), 60–74. Retrieved December 16, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129961577&site=ehost-live

Rodnyansky, A., & Darmouni, R. (2017). The effects of quantitative easing on bank lending behavior. Review of Financial Studies, 30(11): 3858–3887. Retrieved December 9, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=125772886&site=ehost-live

Šehović, D. (2015). The impact of the Great Recession on monetary and fiscal policy in developed market economies. Business Systems Research, 6(1), 56–71. Retrieved December 13, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=102701069&site=ehost-live

Vianna, A. C. (2017). Effects of Bush tax cut and Obama tax increase on corporate payout policy and stock returns. Journal of Economics & Finance, 41(3), 441–462. Retrieved December 16, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=123411247&site=ehost-live

Whalen, C. J. (2015). The fiscal multiplier and economic policy analysis in the United States. Contemporary Economic Policy, 33(4), 735–746. Retrieved December 13, 2018 from EBSCO Online Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=109075991&site=ehost-live

Zadanksi, J. (2017). National statistics: Modern practices and influence on fiscal and monetary policy. Issues in Political Economy, 26(1), 134–161. Retrieved December 13, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124962077&site=ehost-live

Expansionary Fiscal Policy

On this Page

Subject Terms

Expansionary Fiscal Policy

Abstract

Overview

Applications

Issues

Terms & Concepts

Bibliography

Suggested Reading