Expansionary and Contractionary Fiscal Policies

Fiscal policies are carried out by the legislative and sometimes, the executive branch of the government. The two main instruments of fiscal policy are taxes and government expenditure. The government amasses taxes to finance its expenditures. Therefore, fiscal policy can affect production and may be used as an instrument for economic stabilization. It can either be contractionary or expansionary.

The Government Budget

A government budget is a document prepared by a political entity. A budget presents the amount of revenue the political entity aims to raise and the modalities it will use to raise it. Above all, a budget proposes how the revenue would be spent in the coming financial year.

Budget Deficit

A government’s expense can surpass its revenue in a financial year hence creating a budget deficit. A budget deficit is a negative difference between expenditures and tax revenues for a fixed period of time. The government finances the budget deficit by borrowing when it issues long-term and interest-bearing bonds. These outstanding bonds and payments are known as the national debt.

Budget Surplus

When government expenditures are less than the tax revenues in any given financial year, the government runs on a budget surplus during that particular year. The surplus is simply the difference between government expenditure and tax revenues.

Balanced Budget

When revenues and government expenditures are equal, the government will run on a balanced budget during the financial year in question.

Expansionary Fiscal Policy

During a recession, the government employs idle resources and tries to boost economic output. This increased spending makes the aggregate demand to increase; hence, a higher real GDP. This is referred to as an expansionary fiscal policy. It is usually an attempt to raise employment rates and, subsequently, output. The expansionary policy includes:

• deficit spending;
• tax cuts; and/or
• subsidies.

Contractionary Fiscal Policy

Contractionary fiscal policy is explained as a decline in government expenditure. Alternatively, it can be defined as a raise in taxes that causes the government’s budget surplus to increase, or its budget deficit to decrease. A budget deficit or surplus usually determines the type of fiscal policy either as contractionary or expansionary. Contractionary fiscal policy includes:

• budget surplus; and/or
• increased tax rates.

Question

Which one of the following is least likely a reason to use fiscal deficits as an expansionary tool?

A. The government may be crowding out private investments

B. The government may stimulate employment when there is substantial unemployment in the economy

C. The government may facilitate tax changes to reduce distortions in the economy

Solution

The correct answer is A.

A common argument against raises in fiscal deficits is that the additional borrowing to fund the deficit in the financial markets will displace private-sector borrowing that would otherwise be invested by corporations that would create economic growth. This is referred to as “crowding-out.”

Options B and C are reasons to use budget deficits.

Reading 16 LOS 16s:

Determine whether a fiscal policy is expansionary or contractionary.