Understanding Fiscal Policy: Expansionary and Contractionary Measures

Fiscal policy can be defined as governments' actions to influence an economy through the use of taxation and spending. This type of policy is used when policymakers believe the economy needs outside help to adjust to a desired point. Typically, a government has a desire to maintain steady prices, employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order.

Fiscal policy can be used to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which includes consumption, investment, government spending, and net exports.

Expansionary Fiscal Policy

When an economy is in a recession, expansionary fiscal policy is in order. Typically, this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap—meaning that aggregate demand (i.e., GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending, which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result in closing the recessionary gap and helping an economy grow.

Contractionary Fiscal Policy

Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or, for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap, a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease the aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.