Expansionary and Contractionary Fiscal Policy (2024)

Are you living in an economy that is facing a recession or is crippled by inflation? Ever wonder what governments are really doing to restore an economy that is experiencing a recession? Or an economy crippled by inflation? Likewise, are governments the only entities who have sole control in restoring stability in an economy? Expansionary and contractionary fiscal policies are the answer to all our problems! Well, maybe not all our problems, but these macroeconomic tools used by our leaders and also central banks, can definitely be the solution to changing the direction of an economy. Ready to learn about the difference of expansionary and contractionary fiscal policies and more? Then keep scrolling!

Expansionary and Contractionary Fiscal Policy Definition

It is essential to understand what fiscal policy is before discussing expansionary and contractionary fiscal policies.

Fiscal policy is the manipulation of government expenditure and/or taxation to alter the level of aggregate demand in the economy. Fiscal policy is used by the government to manage certain macroeconomic conditions. Depending on the conditions, these policies include either increasing or decreasing taxes and increasing or decreasing government spending. With the use of fiscal policy the government aims to achieve their intended goal of managing the direction of the economy. Implementation of these policies results in a change in the aggregate demand and the corresponding parameters such as aggregate output, investment and employment.

Expansionary Fiscal Policy occurs when the government decreases taxes and/or increases its spending to increase aggregate demand in the economy

Contractionary Fiscal Policy occurs when the government increases taxes and/or decreases its spending to decrease aggregate demand in the economy

The goal of expansionary fiscal policy is to reduce deflation and unemployment and to increase economic growth. Implementation of expansionary fiscal policies often results in the government incurring deficits as they are spending more than they are accumulating through tax revenue. Governments implement expansionary fiscal policy to pull an economy out of a recession and to close the negative output gap.

Negative output gap occurs when the actual output is below the potential output

The goal of contractionary fiscal policy is to reduce inflation, achieve steady economic growth and sustain the natural rate of unemployment - equilibrium level of unemployment resulting from frictional and structural unemployment. Governments often use contractionary fiscal policy to reduce their budget deficits as they are spending less and accumulating more in tax revenue during those periods. Governments implement contractionary fiscal policies to slow down the economy before it reaches the peak turning point in the business cycle to close the positive output gap.

Positive output gap occurs when the actual output is above the potential output

Learn more about potential and actual output in our article on Business Cycles!

Expansionary and Contractionary Fiscal Policy Examples

Let's take a look at some examples of expansionary and contractionary fiscal policies! Remember, the primary aim of an expansionary fiscal policy is to stimulate aggregate demand, whilst of contractionary fiscal policy - to lower aggregate demand.

Expansionary fiscal policies examples

Governments can reduce the tax rate to stimulate consumption and investment in the economy. As individual disposable income increases due to a reduction in taxes, more consumer spending would go towards purchasing goods and services. As the tax rate for businesses decreases, they will be willing to undertake more investments, thereby creating more economic growth.

Country A has been in a recession since November 2021, the government has decided to enact the expansionary fiscal policy by reducing income tax by 3% on monthly income. Sally, who resides in Country A and is a teacher by profession, earns $3000 before taxes. After the introduction of the income tax reduction, Sally's gross monthly income will be $3090. Sally is ecstatic because now she can consider enjoying time out with her friends as she has some extra disposable income.

Governments can increase their spending to increase the aggregate demand in the economy.

Country B has been in a recession since November 2021, the government has decided to enact the expansionary fiscal policy by increasing government spending and completing the subway project which was underway prior to the recession. Access to a subway will allow the public to commute to work, schools and other destinations, which will reduce their transportation cost, as result allowing them to also save or spend on other things.

Governments can increase transfers by increasing availability of social welfare benefits to the public in order to increase household income and spending by extension.

Country C has been in a recession since November 2021, the government has decided to enact the expansionary fiscal policy by increasing government transfers through providing benefits to families and individuals who have lost their jobs during the recession. The social benefit of $2500 will allow individuals to spend and provide for their families as needed.

Contractionary fiscal policies examples

Governments can increase the tax rate to reduce consumption and investment in the economy. As individual disposable income decreases due to an increase in taxes, less consumer spending would go towards purchasing goods and services. As the tax rate for businesses increases, they will be willing to undertake fewer investments, thereby slowing down economic growth.

Country A has been experiencing a boom since February 2022, the government has decided to enact a contractionary fiscal policy by increasing income tax by 5% on monthly income. Sally, who resides in Country A and is a teacher by profession, earns $3000 before taxes. After the introduction of the increase in income tax, Sally's gross monthly income will reduce to $2850. Sally needs to readjust her budget now because of the reduction in her monthly income as she may not be able to spend as much as she previously could.

Governments can decrease their spending to decrease the aggregate demand in the economy.

Country B has been experiencing a boom since February 2022 and the government has decided to enact a contractionary fiscal policy through decreasing government spending on defense. This will slow down the expenditure in the economy and assist in getting a hold of inflation.

Governments can decrease transfers by reducing availability of social welfare benefits to the public in order to reduce household income and spending by extension.

Country C has been experiencing a boom since February 2022, the government has decided to enact a contractionary fiscal policy by eliminating the social benefit program of providing a monthly supplementary income of $2500 to households. The elimination of the social benefit of $2500 will reduce expenditure by households, which will assist in reducing the rising inflation.

Difference between Expansionary Fiscal Policy and Contractionary Fiscal Policy

The figures below demonstrate the difference between the expansionary fiscal policy and contractionary fiscal policy.

Fig. 1 - Expansionary Fiscal Policy

In Figure 1, the economy is in a negative output gap demonstrated by the (Y1, P1) coordinates, and output is below the potential output. Through the implementation of an expansionary fiscal policy the aggregate demand shifts from AD1 to AD2. The output is now at a new equilibrium at Y2 - closer to the potential output. This policy would result in consumer disposable income increasing and by extension increasing expenditure, investment and employment.

Fig. 2 - Contractionary fiscal policy

In Figure 2, the economy is at the peak of the business cycle or, in other words, experiencing a boom. It is currently at (Y1, P1) coordinates and actual output is above potential output. Through the implementation of a contractionary fiscal policy, the aggregate demand shifts from AD1 to AD2. The new level of output is at Y2 where it is equal to potential output. This policy would result in consumer disposable income decreasing, resulting in a decrease in expenditure, investment, employment and inflation.

The key difference between the expansionary fiscal policy and the contractionary fiscal policy is that the former is used to expand aggregate demand and close a negative output gap, whereas the latter is used to shrink aggregate demand and close a positive output gap.

Compare and Contrast Expansionary and Contractionary Fiscal Policy

The tables below describe the similarities and differences of the expansionary and contractionary fiscal policies.

Table 1. Expansionary & contractionary fiscal policy similarities - Vaia Originals

Table 2. Expansionary & contractionary fiscal policy differences, Vaia Originals

Expansionary and Contractionary Fiscal and Monetary Policy

Another tool used to influence the economy besides expansionary and contractionary fiscal policy is monetary policy. These two types of policies can be used hand-in-hand to stabilize an economy that is either suffering from a recession or experiencing a boom.Monetary policy is the efforts of the central bank of a nation to stabilize the economy through influencing the money supply and influencing credit through interest rates.

The monetary policy is implemented through the central bank of a nation. Monetary policy in the U.S. is controlled by the Federal Reserve, also known as the Fed. The Fed has the capacity to act faster than the government to take action when the economy is either facing a recession or experiencing a boom. Given this, there are two types of monetary policy, just like fiscal policy: expansionary and contractionary monetary policy.

Expansionary monetary policy is implemented by the Fed when the economy is facing a downturn or is in a recession. The Fed will reduce interest rates to increase credit and will increase the money supply in the economy, thereby allowing expenditure and investment to increase. This will drive the economy towards economic growth.

Contractionary monetary policy is implemented by the Fed when the economy is facing an increasing amount of inflation due to a boom in the economy. The Fed will increase the interest rate to reduce credit and will reduce money supply in the economy in order to slowdown expenditure and prices. This will drive the economy towards stabilization and will help decrease inflation.