Expansionary fiscal policy and contractionary fiscal policy

By the end of this section, you will be able to:

• Explain how expansionary fiscal policy can shift aggregate demand and influence the economy
• Explain how contractionary fiscal policy can shift aggregate demand and influence the economy

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure illustrates.

The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

A Healthy, Growing Economy In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.

For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.

Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

Now that you know about the Federal Reserve’s policy tools, let’s see how the Fed uses the tools to achieve its dual mandate—maximum employment and price stability.

How Expansionary Monetary Policy Works

Suppose the economy weakens and employment falls short of the Fed’s maximum employment goal. Meanwhile, the inflation rate is showing signs that it will fall below the target. The Federal Open Market Committee (FOMC) might decide to use expansionary monetary policy to provide stimulus for the economy. That is, the FOMC could lower its target range for the federal funds rate (FFR).

When doing so, the Fed would decrease its administered interest rates—interest on reserve balances (IORB), overnight reverse repurchase agreement (ON RRP) offering, and discount—accordingly.

Expansionary Monetary Policy Graph

This animated graph of expansionary monetary policy shows how a cut in the federal funds rate target triggers a decrease in the Fed’s administered rates, which results in a lower federal funds rate.

These actions by the Fed would transmit to other market interest rates and broader financial conditions. Here is how expansionary monetary policy translates into the economy:

• Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services and businesses to invest in new equipment.
• The increase in consumption spending by consumers and investment spending by businesses increases the overall demand for goods and services in the economy.
• With increased production, businesses are likely to hire additional employees and spend more on other resources.
• As these increases in spending ripple through the economy, unemployment decreases, moving the economy toward maximum employment.

So, the Fed’s monetary policy tools can be effective for moving the economy back toward the maximum employment component of the dual mandate when the economy is weak.

How Contractionary Monetary Policy Works

Suppose that inflation has exceeded 2 percent for some time and the Fed recognizes that individuals are starting to expect high and rising inflation going forward. In this situation, the FOMC might decide to use contractionary monetary policy to bring actual and expected inflation back toward its target, to maintain price stability.

To do this, the FOMC could raise its target range for the federal funds rate (FFR) and increase the administered rates—interest on reserve balances (IORB) rate, overnight reverse repurchase agreement (ON RRP) offering rate, and discount rate—accordingly.

Contractionary Monetary Policy Graph

This animated graph of contractionary monetary policy shows how an increase in the federal funds rate target triggers an increase in the Fed’s administered rates, which results in a higher federal funds rate.

Here is how contractionary policy actions by the Fed would transmit to other market interest rates and broader financial conditions.

• Higher interest rates increase the cost of borrowing money, which discourages consumers from spending on some goods and services and reduces businesses’ investment in new equipment.
• The decrease in consumption spending by consumers and in investment spending by businesses decreases the overall demand for goods and services in the economy.
• With decreased production, businesses are less likely to hire additional employees and spend more on other resources.
• As these decreases in spending ripple through the economy, inflationary pressures would diminish and the inflation rate would fall back toward 2 percent.

Note that the goal of contractionary monetary policy is to decrease the rate of demand for goods and services, not to stop it. So, higher interest rates through contractionary policy can be used to dampen inflation and move the economy back to the price stability component of the dual mandate.

What is the difference between expansionary fiscal policy and contractionary fiscal policy?

What are examples of expansionary and contractionary fiscal policy?

What is the difference between contractionary policy and expansionary policy?

What are examples of contractionary fiscal policy?