Expansionary fiscal policy is designed to stimulate the economy during or anticipation of a business-cycle contraction. The goal of expansionary fiscal policy is to close a recessionary gap, decrease the unemployment, and rate stimulate the economy. Expansionary monetary policy is an increase in the quantity of money in circulation, with corresponding reductions in interest rates, for the expressed purpose of stimulating the economy to correct or prevent a business-cycle contraction and to address the problem of unemployment. Both fiscal policy and monetary policy support each other in the processes of moving the economy out of a recession.
“Expansionary fiscal policy accomplishes stimulating the economy by increasing aggregate expenditures and aggregate demand through an increase in government spending or a decrease in taxes” (Amacher & Pate, 2012). “Expansionary fiscal policy leads to a larger government budget deficit or a smaller budget surplus” (Carol, 2013). In general, expansionary fiscal policy works through the two sides of the government fiscal budget—spending and taxes. However, it’s often useful to separate these two sides into three specific tools—government purchases, taxes, and transfer payment.
One of the three fiscal policy tools available to the government sector is government purchases. Government purchases are expenditures by the government sector, especially those by the federal government, on final goods or services. It is that portion of gross domestic product purchased by governments. “These purchases are used to buy everything from aircraft carriers to paper clips, from office furniture to highway construction, from traffic lights to teacher salaries” (Gnocchi, 2013). The actual purchases are typically undertaken by individual government agencies. Highway construction, for example, is undertaken with funds appropriated to the Department of Transportation. “Aircraft carriers are financed with funds appropriated to the Department of Defense” (Weil, 2008).
Expansionary fiscal policy involves an increase in the funds appropriated to these assorted agencies. The agencies then make the additional purchases which stimulate aggregate production, boost income, and increase the level of employment (Amacher & Pate, 2012). While an increase in government purchases have been used frequently over the years to implement expansionary fiscal policy, it can be a relatively involved process. Moreover, additional government purchases lead to a relatively larger government sector (Carol, 2013). For these reason, policy makers often opt for the second fiscal policy tool, taxes.
The second of three fiscal policy tools are taxes, primarily personal income taxes levied by the federal government, but other taxes are also used (Gnocchi, 2013). Taxes are the involuntary payments that the government sector imposes on the rest of the economy to generate the revenue needed to provide public goods and to undertake other government functions (Martin, 2013). Personal income taxes are more specifically the taxes collected on the income received by members of the household sector (Gnocchi, 2013).
The federal income tax system, administered by the Internal Revenue Service (IRS), involves a set of tax rates that are applied to the income received by the taxpayers. The bulk of the taxes are withheld from employee paychecks by then paid to the federal government by employers, and discrepancy between taxes withheld and the actual tax liability is then settled when income tax returns are filed at the end of the year (Weil, 2008).
Expansionary fiscal policy involves either a decrease of the income tax rates or a onetime rebate of taxes previously paid. The reduction in taxes provides the household sector with additional disposable income that can be used for consumption expenditures, which then stimulates aggregated production and employment and leads to further increases in income (Amacher & Pate, 2012). Since tax changes tend to be administratively easier to implement, they are often preferred over government purchases when conduction expansionary fiscal policy. Moreover, political leaders and voters usually prefer a deduction in the tax burden to an increase in government spending (Weil, 2008).
The third fiscal policy tool is transfer payments. The third fiscal policy tool is transfer payments. Transfer payments are payments made by the government sector to the household sector with no expectations of productive activity in return. The three common transfer payments are Social Security benefits to the elderly and disable, unemployment compensation to the unemployed, and welfare to the poor (Weil, 2008).
Like the income tax system, transfer payments rely on a payment schedule based on qualifying characteristics of the recipients — age, employment status, income, etc. Those who meet the criteria then receive payments.
Expansionary fiscal policy involves either an increase in payment schedule for one or more of the transfer systems or perhaps some sort of across-the-board lump-sum payment to all who qualify. That is, the unemployment compensation might be increased by 5 percent or all Social Security recipients might receive an extra $500 payment (Carol, 2013). The increase in transfer payments provides the household sector with additional disposable income that can be used for consumption expenditures, which then stimulates aggregate production and employment and leads to further increases in income (Weil, 2008).
Expansionary fiscal policy is used to address business-cycle instability that gives rise to the problem of unemployment, that is, to close a recessionary gap. A recessionary gap exists if the existing level of aggregate production is less than what would be produced with the full employment of resources. This gap arises during a business-cycle contraction and typically gives rise to higher rates of unemployment (Weil, 2008).
A recessionary gap is commonly illustrated using the aggregate market (AS-AD analysis). The exhibit to the right presents the standard aggregate market (Gnocchi, 2013). The vertical long-run aggregate supply curve, labeled LRAS, marks full-employment real production. Long-run equilibrium in the aggregate market necessarily results in full-employment real production (Gnocchi, 2013).
The positively-sloped short-run aggregate supply curve is labeled SRAS. Short-run equilibrium in the aggregate market occurs at the price level and real production corresponding to the intersection of the aggregate demand curve and this SRAS curve (Gnocchi, 2013). Should short-run real production fall short of full-employment real production, then a recessionary gap results (Gnocchi, 2013).
To include an aggregate demand curve that generates a recessionary gap for this aggregate market. Doing so reveals a short-run equilibrium level of real production that is less than full employment, which is a recessionary situation (Weil, 2008). Note that the aggregate demand curve intersects the SRAS curve at a real production level to the left of the LRAS curve. This means the short-run real production is less than full-employment real production. The difference between short-run equilibrium real production and full-employment real production is the recessionary gap (Weil, 2008).
Expansionary fiscal policy is designed to close a recessionary gap by changing aggregate expenditures and shifting the aggregate demand curve. A recessionary gap is closed with a rightward shift of the aggregate demand curve. The recessionary gap can be closed with expansionary fiscal policy — an increase in government purchases, a decrease in taxes, or an increase in transfer payments. This policy shifts the aggregate demand curve to the right and closes the gap (Weil, 2008). If done correctly, the aggregate demand curve intersects the short-run aggregate supply curve at the full employment level of aggregate production indicated by the long-run aggregate supply curve (Gnocchi, 2013).
Expansionary monetary policy is an increase in the quantity of money in circulation, with corresponding reductions in interest rates, for the expressed purpose of stimulating the economy to correct or prevent a business-cycle contraction and to address the problem of unemployment. In days gone by, monetary policy was undertaken by printing more paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking (Amacher & Pate, 2012).
The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (buying U.S. Treasury securities), a lower discount rate, and lower reserve requirements. In practice, the Fed primarily uses open market operations for this control (Amacher & Pate, 2012). An important side effect of expansionary monetary policy is control of interest rates. As the quantity of money increases, banks are willing to make loans at lower interest rates.
Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool (Amacher & Pate, 2012).
Expansionary monetary policy occurs when the Fed buys U.S. Treasury securities through open market operations. The Fed pays for these Treasury securities with bank reserves, which results in an increase in total amount of reserves held by the banking system. Banks are inclined to lend these extra reserves at lower interest rates, which increase checkable deposits and the money supply (Amacher & Pate, 2012).
The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans (Carol, 2013). The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions (Weil, 2008).
Expansionary monetary policy occurs when the Fed lowers the discount rate. This makes it easier for commercial banks to borrow reserves from the Fed. As with open market operations, the additional bank reserves held by the banking system induces more loans at lower interest rates, which increases checkable deposits and the money supply (Amacher & Pate, 2012).
However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply (Weil, 2008). For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.
Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to backup deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements (Gnocchi, 2013).
Expansionary monetary policy occurs when the Fed lowers reserve requirements. This means banks have more reserves than needed to back up deposits. They can then use these extra reserves to make more loans at lower interest rate, which increases checkable deposits and the money supply (Amacher & Pate, 2012).
Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements (Weil, 2008). For this reason, reserve requirements are seldom used as a monetary policy tool (Weil, 2008).
All three tools, used separately or together, increase the amount of money in circulation and reduce interest rates. This combination of extra money and lower interest rates stimulate the economy by inducing additional expenditures on aggregate production, especially consumption expenditures and investment expenditures. With greater aggregate production, more resources are used, employment is greater, and unemployment declines (Weil, 2008). This is precisely the stimulation needed of the economy is in a business-cycle contraction or recession with high unemployment rates. It is also recommended if the economy appears to be headed toward a business-cycle downturn. In fact, because monetary policy does not affect the economy immediately, implementing expansionary monetary policy before the economy a contraction sets it is the preferred strategy. In this way, the recession and higher unemployment are not just "fixed," but avoided completely (Martin, 2013).
References
Amacher, R., & Pate, J. (2012). Principles of Macroeconomics. San Diego, California, USA.
Carol, J. (2013). Economics. Retrieved from Diffen: http://www.diffen.com/difference/Fiscal_Policy_vs_Monetary_Policy
Gnocchi, S. (2013, April 1). American Economic Journal: Macroeconomics. Retrieved from Monetary Commitment and Fiscal Discretion: The Optimal Policy Mix: http://ehis.ebscohost.com.proxy-library.ashford.edu/eds/pdfviewer/pdfviewer?vid=5&sid=20d40112-af8f-4ed1-bb50-051c838bfd86%40sessionmgr113&hid=104
Martin, F. M. (2013, Feb 1). International Economic Review. Retrieved from Goverment policy in Monetarty economics: http://ehis.ebscohost.com.proxy-library.ashford.edu/eds/pdfviewer/pdfviewer?sid=20d40112-af8f-4ed1-bb50-051c838bfd86%40sessionmgr113&vid=5&hid=104
Weil, D. N. (2008). The Concise Encyclopedia of Economics Fiscal Policy. Retrieved from Library of Economics and Liberty: http://www.econlib.org/library/Enc/FiscalPolicy.html