Expansionary and Contractionary Fiscal Policy: Videos & Practice Problems

The government plays a crucial role in managing the economy through fiscal policy, which involves adjusting spending and taxation to influence aggregate demand. When the economy is in a recession, characterized by real GDP falling below its potential output and rising cyclical unemployment, the government may implement expansionary fiscal policy to stimulate economic growth.

In a recession, the aggregate demand and aggregate supply (ADAS) model illustrates that the equilibrium output is below the long-run aggregate supply (LRAS), indicating that the economy is not operating at its full potential. To address this, the government can increase its spending, which directly contributes to the GDP equation. This increase in government purchases raises aggregate demand, shifting the AD curve to the right. As a result, the economy moves towards its long-run equilibrium, achieving a higher price level and increased GDP.

Additionally, the government can lower taxes to boost disposable income for consumers. This increase in disposable income leads to higher consumption, further shifting the aggregate demand curve to the right. Both strategies aim to restore the economy to its potential GDP, effectively reducing unemployment and fostering economic recovery.

In summary, through expansionary fiscal policy—either by increasing government spending or reducing taxes—the government seeks to enhance aggregate demand, thereby promoting economic growth and stabilizing the economy during periods of recession.

Contractionary fiscal policy is implemented when an economy is experiencing a boom, leading to rising inflation. In this scenario, real GDP exceeds its potential output, resulting in overemployment, where individuals who typically would not be working are now employed due to abundant job opportunities and higher wages. This situation is unsustainable, as it can lead to increased price levels and economic instability.

In graphical terms, the short-run equilibrium is positioned beyond the potential output, indicating that the economy is operating above its long-run aggregate supply. To address this, the government aims to decrease aggregate demand to control inflation. This can be achieved through fiscal measures such as reducing government spending and increasing taxes. By decreasing government purchases, the aggregate demand curve shifts to the left, moving the economy back towards long-run equilibrium.

The equation that encapsulates this relationship is:

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

where Y represents total output (GDP), C is consumption, I is investment, G is government spending, and (X - M) represents net exports. By reducing G and increasing taxes, consumption (C) is also affected, leading to a decrease in overall demand.

As a result, the economy transitions from a state of high GDP and elevated price levels to a more sustainable long-run equilibrium, where GDP aligns with its potential output and price levels decrease. This process highlights the similarities between contractionary fiscal policy and both expansionary fiscal and monetary policies, providing a comprehensive understanding of how different economic tools can influence aggregate demand and overall economic stability.