AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP.
#THE GOAL OF EXPANSIONARY FISCAL POLICY IS FULL#
If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. A key issue of expansionary fiscal policy is the state of the economy.The impact of an increase in AD depends on situation of the economy. Timing of fiscal policy – amount of spare capacity Therefore, expansionary fiscal policy helps to offset the rise in private sector saving and injects money into the circular flow and doesn’t cause crowding out.ģ. However, in a liquidity trap/recession, private saving rates rise rapidly.Crowding out occurs when the government spends more, but because they borrow from the private sector, the private sector reduces private sector investment and therefore government spending ‘crowds out’ private sector spending.However, the economy was also experiencing falling house prices, lower confidence and a shortage of credit because of all these factors, expansionary fiscal policy was relatively ineffective in promoting rapid economic growth. For example in 2008, the US tried to cut taxes in theory, this lower tax should boost spending.Lower income tax may fail to boost AD if we also have falling house prices and low confidence.The impact of expansionary fiscal policy will depend on many factors:ġ. If private investors buy government bonds, they have less to use for private sector investment. (this happened in Eurozone without Central Bank to purchase bonds, but bond yields fell in UK/US due to strong demand for bonds. Larger deficits could cause markets to fear debt default and push up interest rates on government debt. Expansionary fiscal policy and government borrowing In 2009/10, UK government borrowing increased as they pursued expansionary fiscal policy.Ī potential problem of expansionary fiscal policy is that it will lead to an increase in the size of a government’s budget deficit. Fiscal policy can make use of this rise in saving and spend more. One argument for fiscal policy is that the government spend more to offset the rise in private sector saving and fall in private sector spending.Īt the start of the recession in 2009, the saving ratio rose rapidly as consumers cut back on spending. From the government’s initial injection the final increase in real GDP will be more than the initial investment.Įxpansionary fiscal policy can also lead to inflation because of the higher demand in the economy. For example, builders who gain a job will also spend more creating jobs elsewhere in the economy. This injection of money into the economy can also cause a positive multiplier effect. Higher consumption will increase aggregate demand and this should lead to higher economic growth.Īlternatively, if the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand. If the government cut income tax, then this will increase the disposable income of consumers and enable them to increase spending. Expansionary Fiscal Policy – AD/AS Impact of expansionary fiscal policy – increases AD and leads to higher real GDP and inflation. This enables the economy to recover more quickly than a laissez-faire approach. He argued this injection of government spending could stimulate economic activity and get the unemployed resources back into productive use. Keynes said expansionary fiscal policy should be used during a recession – when there is unemployment, surplus saving and falling real output. This involves the government seeking to increase aggregate demand – through higher government spending and/or lower tax.Įxpansionary fiscal policy is usually financed by increased government borrowing – and selling bonds to the private sector. Definition of expansionary fiscal policy.
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