Expansionary and Contractionary Fiscal Policy Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Review questions for this study guide can be found at:

Fiscal Policy, Economic Growth, and Productivity Review Questions for AP Economics

Main Topics: Expansionary Fiscal Policy, Contractionary Fiscal Policy, Deficits and Surpluses, Automatic Stabilizers

This section of the chapter uses AD and AS to illustrate how fiscal policy can work in theory. Fiscal policy stresses the importance of a hands-on role for government in manipulating AD to "fix" the economy. Difficulties in fiscal policy and the supply-side perspective are addressed in the following section.

Expansionary Fiscal Policy

When the economy is suffering a recession, real GDP is low and unemployment is high. In the AD and AS model, a recessionary equilibrium is located in the horizontal range of AS, as seen in Figure 15.1. If the government increases its spending or lowers net taxes, the AD curve increases. Net taxes, if you recall, are tax revenues minus transfer payments. In this range of AS, the economy should experience the full magnitude of the multiplier with very little inflation. Of course if the government is using tax cuts, rather than government spending, to expand the economy, the multiplier is smaller; so to get the same increase in real GDP, the size of the tax cut must be larger than an increase in government spending.

Expansionary and Contractionary Fiscal Policy

Contractionary Fiscal Policy

If the economy is operating beyond full employment, and inflation is becoming a problem, the government might need to contract the economy. This inflationary equilibrium is seen in the vertical range of the AS curve, as seen in Figure 15.2. This can be done by decreasing government spending or by increasing taxes, both of which cause a leftward shift in AD. In this range of AS, the economy might see very little decrease in real GDP, but ideally a substantial decrease in the rate of inflation.

Expansionary and Contractionary Fiscal Policy

Are Prices Sticky?

Do prices fall, as Figure 15.2 seems to indicate? One of the points of contention is whether the price level can fall. Many economists (Keynesians) predict that prices are fairly inflexible, or "sticky" in the downward direction, so efforts to fight inflation are really efforts to slow inflation, not to actually lower the price level. Conversely, Classical School economists believe that the long-run economy naturally adjusts to full employment and so they see the AS curve as vertical. This argument implies that prices are flexible and can rise and fall as seen above.

Deficits and Surpluses

When the government starts to adjust spending and/or taxation, there is an effect on the budget. A budget deficit exists if government spending exceeds the revenue collected from taxes in a given period of time, usually a year. A budget surplus exists if the revenue collected from taxes exceeds government spending.

The Difference Between Deficit and Debt

An annual budget deficit occurs when, in one year, the government spends more than is collected in tax revenue. To pay for the deficit, the government must borrow funds. When deficits are an annual occurrence, a nation begins to accumulate a national debt. The national debt is therefore an accumulation of the borrowing needed to cover past annual deficits.

Expansionary Policy

If the economy is in a recession, the appropriate fiscal policy is to increase government spending or lower taxes. When the government spends more, or collects less tax revenue, budget deficits are likely. There are two ways to finance the deficit, and each has the potential to weaken the expansionary policy.

  • Borrowing. If a household wants to spend beyond its means, it enters the market for loanable funds as a borrower. The borrowed funds provide a short-term ability to purchase goods and services, but must be paid back, with interest, when the loan is due. The same is true when the government borrows, but when an entity as large as the federal government is borrowing from the banking system or from the public in the form of Treasury securities (i.e., bonds), it decreases the supply of loanable funds available to private borrowers. A decrease in the supply of loanable funds tends to drive up the price, or real rate of interest. So what? Well, if the goal is to expand the macroeconomy, then borrowing to finance the deficit slows down the expansion by increasing interest rates. This crowding out effect is examined in the next section of this chapter.
  • Creating Money. The creation of new money to fund a deficit can avoid the higher interest rates caused by borrowing. The primary disadvantage of creating more money is the risk of inflation, which can also lessen the effectiveness of expansionary fiscal policy. The effect that inflation has on the multiplier was illustrated in the previous chapter, and more detailed effects of expanding the money supply are looked at in the next chapter.

Contractionary Policy

If the economy is operating above full employment, the appropriate fiscal policy is to lower government spending or raise taxes. When the government spends less, or collects more tax revenue, a budget surplus can occur. The effectiveness of the contractionary fiscal policy depends upon what is done with the surplus.

  • Pay down debt. If the government pays down debt and retires bonds ahead of schedule, the supply of loanable funds increases, decreasing interest rates. Lower interest rates stimulate investment and consumption, which counters the contractionary fiscal policy and lessens the downward effects on the price level.
  • Do nothing. By making regularly scheduled payments on Treasury bonds and retiring them on schedule, idle surplus funds are removed from the economy. By not allowing these funds to be recirculated through the economy, the anti-inflationary fiscal policy can be more effective.
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