Fiscal Policy

The Role of Fiscal Policy Based on the Keynesian Perspective

Fiscal policy is the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.

Fiscal Policy can be Expansionary or Contractionary:

  • Expansionary Fiscal Policy (Fiscal Stimulus) , generally speaking, consists in an increase in government spending, a decrease in taxes (tax cuts), or a combination of both.
  • Contractionary Fiscal Policy , generally speaking, consists in a decrease in government spending, an increase in taxes, or a combination of both.

Different economic conditions call for a different set of fiscal policies.

Typically, in the presence of a recessionary gap (remember, short run equilibrium RGDP is less than Potential GDP), expansionary fiscal policy is needed to close the gap. For example, due to the presence of the multiplier effect, to close a recessionary gap of $5 billion, government spending, G, needs to increase by $1 billion if the government spending multiplier, GM, is 5. (23)

Expansionary Fiscal Policy

Figure 6.7 illustrates how to close a recessionary gap of 1 trillion dollars, the initial increase in government spending, or the initial tax cut, need only be a fraction of the gap. Once the multiplier effect has taken full effect, AD0 shifts to AD1, and the gap is closed — the economy has reached its potential GDP. (23)

This figure illustrates how to close a recessionary gap of 1 trillion dollars, the initial increase in government spending, or the initial tax cut need only be a fraction of the gap. Once the multiplier effect has taken fill effect, AD0 shifts to AD1, and the gap is closed — the economy has reached its potential GDP.
Figure 6-7: Expansionary Fiscal Policy by FSCJ is licensed under CC-BY-4.0.

Contractionary Fiscal Policy

On the other hand, in the presence of an inflationary gap (remember, short run equilibrium RGDP is higher than Potential GDP), contractionary fiscal policy is needed to close the gap. For example, due to the presence of the multiplier effect, to close an inflationary gap of $4 billion, Taxes on Personal Income, T, need to increase by $1 billion, if the tax multiplier, T , is 4.

Figure 6.8 illustrates an economy experiencing an inflationary gap of 1 trillion dollars. The initial decrease in government spending, or the initial increase in taxes, need only be a fraction of the gap. Once the multiplier effect has taken full effect, the AD curve shifts all the way down to the left to intersect both AS and the Potential GDP curves, and eliminate the inflationary gap. (23)

This figure illustrates an economy experiencing an inflationary gap of 1 trillion dollars. The initial decrease in government spending, or the initial increase in taxes need only be a fraction of the gap. Once the multiplier effect has taken full effect, the AD curve shifts all the way down to the left to intersect both AS and the Potential GDP curves, and eliminate the inflationary gap.
Figure 6-8: Contractionary Fiscal Policy Figure by FSCJ is licensed under CC-BY-4.0.