Why is expansionary fiscal policy used

By utilising subsidies, transfer payments inclusive of welfare programs , and tax cuts on wages, expansionary fiscal policy brings more money into the hands of consumers to give them more purchasing power. It also lowers unemployment by contracting public works or recruiting new government employees, all of which raise demand and boost consumer spending driving nearly 70 per cent of the economy.

The other three components of the gross domestic product are government expenditure, net exports, and investment by industry. Cutting corporate taxes put more money into the hands of companies, which the government hopes would be diverted into new projects and growing employment.

Tax cuts generate employment in this way, so if the company already has enough cash, it can use the cut to buy back stocks or purchase new businesses. The supply-side economics theory suggests reducing corporate taxes rather than payroll taxes and supports lower capital gains taxes to boost spending by companies. The two significant examples include increased government spending as well as tax cuts. These policies seek to raise aggregate demand while leading to deficits or drawing the decline of budget surpluses.

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What Is an Expansionary Policy? Key Takeaways Expansionary policy seeks to stimulate an economy by boosting demand through monetary and fiscal stimulus. Expansionary policy is intended to prevent or moderate economic downturns and recessions. Though popular, expansionary policy can involve significant costs and risks including macroeconomic, microeconomic, and political economy issues.

Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms Economic Stimulus Economic stimulus refers to attempts by governments or government agencies to financially kickstart growth during a difficult economic period. What Is Fiscal Policy? Fiscal policy uses government spending and tax policies to influence macroeconomic conditions, including aggregate demand, employment, and inflation.

At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending. However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending.

Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.

Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As Figure shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand AD 0 and aggregate supply SRAS 0 occurs at equilibrium E 0 , which is an output level above potential GDP.

In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD 1 , and causing the new equilibrium E 1 to be at potential GDP, where aggregate demand intersects the LRAS curve.

Again, the AD—AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand. Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes.

Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP. What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?

What is the main reason for employing expansionary fiscal policy during a recession? What is the difference between expansionary fiscal policy and contractionary fiscal policy? Under what general macroeconomic circumstances might a government use expansionary fiscal policy?

When might it use contractionary fiscal policy? Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer. Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:.

Alesina, Alberto, and Francesco Giavazzi. Chicago: University Of Chicago Press, Tax cuts , whether they take the form of overall rate decreases or refundable credits put more money straightforwardly into the pockets of customers.

Expanded government spending , through, regularly on open works, to boost the overall level of employment. In these two points, you may have noticed that the most crucial objective of the expansionary fiscal policy is to expand demand in the economy by giving individuals more discretionary cash flow, both to incite customer spending and business investment. Thus, this is not the same as an expansionary monetary policy, which depends on giving securities and bringing interest rates all together down to prod loaning concerning banks and enhancing the money supply.

Related blog: Mutual Funds in India. If the government cuts income tax, at that point this will enhance the disposable cash flow of purchasers and empower them to expand spending. Higher utilization will raise total interest and this should prompt higher financial development. This infusion of money into the economy can likewise cause a positive multiplier impact. For instance, manufacturers who acquire a work will likewise spend additionally making occupations somewhere else in the economy.

From the public authority's underlying infusion the last expansion in genuine GDP will be more than the underlying investment.

Check also: What is the Federal Reserve System? Corporate tax cuts put more money into organizations' hands, which the government expectations will be put toward new investments and expanding business.

In that manner, tax cuts make employment, yet if the organization already has enough money, it might utilize the cut to repurchase stocks or buy new organizations. Relevant study: Corporate goverance overview. The hypothesis of supply-side financial aspects suggests bringing down corporate expenses rather than income taxes, and promoters for lower capital additions charges to expand the business venture.

The expansionary fiscal policy can likewise lead to inflation due to more demand in the economy. We all know that everything comes with pros and cons, so does this.

The main benefit of expansionary fiscal policy is that it works very fast if done accurately. It expands profitability since it targets expanding the money supply. Also, there is a high demand for goods and services, and organizations gear ready for rising production in terms of quality and quantity. It helps fuel the economic growth and development of the nation, particularly during a downturn.

Subsequently, it is commonly embraced during low-development stages. It diminishes decreases in loan applications and interest rates and prompts an expanded overflowing of capital into the economy. There is one more important thing about expansionary fiscal policy, it restores customers' and organizations' confidence.