Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. Expansionary policy can do this by:

1. increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes;
2. increasing investments by raising after-tax profits through cuts in business taxes; and
3. increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services.

Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in Figure 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD₀) and aggregate supply (AS₀) is occurring below the level of potential GDP. At the equilibrium (E₀), a recession occurs and unemployment rises. (The figure uses the upward-sloping AS curve associated with a Keynesian economic approach, rather than the vertical AS curve associated with a neoclassical approach, because our focus is on macroeconomic policy over the short-run business cycle rather than over the long run.) In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD₁, closer to the full-employment level of output. In addition, the price level would rise back to the level P₁ associated with potential GDP.

Figure 2. Expansionary Fiscal Policy. The original equilibrium (E₀) represents a recession, occurring at a quantity of output (Yr) below potential GDP. However, a shift of aggregate demand from AD₀ to AD₁, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E₁ at the level of potential GDP. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P₀ to P₁ that results should be relatively small.

Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of 2008–2009, U.S. government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009.

This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.

The Politics of Expansionary Fiscal Policy

The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy.

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.

Fiscal policy can also be used to slow down an overheating economy. Suppose the macro equilibrium occurs at a level of GDP above potential, as shown in Figure 3. The intersection of aggregate demand (AD₀) and aggregate supply (AS₀) occurs at equilibrium E_0. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD₁, and causing the new equilibrium E₁ to be at potential GDP.

Figure 3. A Contractionary Fiscal Policy. The economy starts at the equilibrium quantity of output Yr, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD₀ to AD₁, leading to a new equilibrium output E₁, which occurs at potential GDP.