Define Expansionary and Contractionary Fiscal Policies

Fiscal policy by Congress can be expansionary or contractionary.

Fiscal policy involves the government's use of its taxation and spending powers to influence the condition and direction of a nation's economy. Fiscal policy can be expansionary or contractionary, depending on whether government spends more or less than it collects in revenue.

Identification

Writing in the online Concise Encyclopedia of Economics, Brown University economist David Weil describes fiscal policy as expansionary when the government runs a deficit, spending more money than it collects in taxes. Contractionary fiscal policy means the government has a surplus, with revenues exceeding expenditures. Weil notes that economists often focus on the change in a deficit rather than the deficit itself. This means that a reduction in the government's budget deficit from the prior year represents contractionary fiscal policy even though a deficit remains.

Effects

Fiscal policy alters the overall, or aggregate, demand for goods and services across the economy. Expansionary fiscal policy, for example, increases aggregate demand either through more government purchases or through higher consumer spending resulting from government tax cuts. However, Weil cautions that deficits cause the government to borrow to meet its expenses. This borrowing results in higher interest rates and may crowd out some private investment.

Considerations

Weil suggests that the long-term impact of fiscal policy is often the opposite of its short-term effects. Fiscal expansion may raise economic output temporarily but leads to lower output than might have been the case without the expansion. Contractionary policy, meanwhile, may hamper output at first but lead to higher economic output later.

References

• Concise Encyclopedia of Economics: Fiscal Policy

Resources

• Congressional Budget Office