Expansionary Fiscal Policy and Aggregate Demand

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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In the 21st century, the realities of a recessionary economy are more vivid than many of us would probably like. In this lesson, you'll learn how the government uses expansionary policy to offset recessionary gaps using real-world examples.

Expansionary Fiscal Policy and Aggregate Demand

Meet Larry of Larry's Limos of Greater Ceelo. They buy cars and turn them into nice limousines that are used for businesses, proms and even government functions. As a result of a recessionary economy, Larry has had to let go of five of his ten factory workers.

Natalie, a single mom with four children, lives just down the street from Larry's Limos. Thanks to the recession, she's been laid off as a receptionist and now receives welfare checks from the government.

Illustration of an aggregate demand curve
Aggregate Demand Curve

When economists talk about a recession, they talk about aggregate demand. Aggregate demand is the total level of demand for goods and services by consumers, businesses, the government and foreigners. It's illustrated using the aggregate demand curve, as you see here.

During a recession, aggregate demand has decreased, leading to lower real GDP, higher unemployment and lower prices. Keynesian economists believe that the government should step in during times like these and stimulate economic growth when consumers, businesses and foreigners may not be spending enough to keep the economy going.

Expansionary fiscal policy is the use of government spending, taxation and transfer payments to stimulate aggregate demand. Whether the government is increasing its own purchases, lowering taxes or raising transfer payments, expansionary fiscal policy always increases at least one component of aggregate demand.

Let's watch Larry and Natalie as they experience firsthand the government's attempt to deal with this recession using expansionary fiscal policy.

Three Examples of Expansionary Fiscal Policy

In our first example, when the government decides to purchase new limousines and sunglasses for every government receptionist, they call Larry at Larry's Limos and they place 2,500 custom orders. Once Larry hangs up the phone, he sprints down the hallway of his office (very excited), opens the door to the production floor and yells at the factory supervisor to call every worker they laid off during the last five years and hire them back.

Okay, so then they make the limousines. Once these orders are done, the sales are counted in real GDP, which means that economic output has increased. Economists would say it this way: 'An increase in government spending raises aggregate demand directly.'

For our second example, the government decides to lower the marginal income tax rates, which leads to an increase in Larry's disposable income from $70,000 a year to $75,000 a year. So, in other words, he was making $70,000, but now he's making $75,000 because the government has lowered the tax rates. He now has an additional $5,000 to spend because his taxes went down.

After thinking about it for a very long time (let's be real, Larry thought about it during the last commercial break of his favorite TV show), Larry decides to put $1,000 of his additional income into his savings account at the First National Bank of Ceelo. Then he spends $4,000 on a rare bird from Australia called a lyrebird that replicates any sound exactly, so he can let it loose in his car factory and find out exactly what his employees are saying about him. This expenditure gets counted in real GDP, and economic output goes up.

Economists would say it this way: 'Lower taxes raise aggregate demand indirectly by increasing disposable income, which leads to higher consumption and therefore higher aggregate demand.'

When Larry bought the bird with his extra income, this was an example of higher consumption. Higher consumption across the economy leads to higher business profits and creates the need for businesses to hire new workers, so unemployment then goes down.

In our last example, Natalie has gone through a rough time recently and is receiving welfare checks from the government, which are known as transfer payments. She's very thankful for this emergency relief, and, at least for the moment, she's depending on her monthly checks. When the government announces an increase in transfer payments, Natalie is thrilled. Her income will go up from $18,000 to $20,000 a year. Now she can expand her grocery budget a little and also buy an old car. These purchases will get counted in the consumption part of aggregate demand, which means that economic output has now increased, and unemployment will likely go down as well.

Once again, economists would say it this way: 'An increase in transfer payments raises aggregate demand indirectly by increasing disposable income, which leads to higher consumption - and that leads to higher aggregate demand.' So this was very similar to the example of lowering taxes.

Each of the scenarios you just heard are examples of expansionary fiscal policy. Now let's take a closer look at how economists illustrate it.

Illustrating Expansionary Fiscal Policy

Illustration of a recessionary gap, also called a contractionary gap
Recessionary Gap Graph New

During a recessionary gap, the economy is below the full employment level. In English, that just means that the job market is really slow and unemployment is higher than what it naturally is. Real GDP is below its potential and inflation is on the low side.

So you can see here what it looks like. The vertical line is the economy's long-run potential. The macroeconomic equilibrium, seen here as the intersection of the aggregate demand curve and the short-run aggregate supply curve, is to the left of the economy's long-run potential, which is the vertical line. Right now, in this recession, aggregate demand is at Q1, which is less than Qp, the economy's potential. The price level, I want you to see, is at P1. As you'll see in a minute, after the government uses expansionary fiscal policy, both aggregate demand and the price level will rise. We'll be able to see the economy escape the recession and increase so that it returns to its long-run potential by watching Q1 go back to Qp, and P1 will rise to a higher level.

If you're a Keynesian, you want to move the macroeconomic equilibrium back to the right, where it crosses the vertical line, or what economists call the economy's long-run potential. (The abbreviation here is LRAS.) Keynesian economists believe that expansionary fiscal policy should be used to offset a recessionary gap, otherwise known as a contractionary gap. Expansionary fiscal policy offsets a recessionary gap, or a contractionary gap, by increasing real GDP and also inflation.

We can illustrate this as an increase, or a rightward shift, of the aggregate demand curve (AD), as you can see here.

For example, suppose the President plans to cut taxes for consumers and also plans to increase defense spending. Real GDP and the price level will both increase, closing the gap between actual output and potential output.

The formula for aggregate demand is: Y = C + I + G + (X - M), which simply means:

Economic output = Consumption + Investment + Government spending + (Exports - Imports).

As we mentioned, the government does three things when they pursue expansionary fiscal policy:

  • Increase government spending
  • Lower taxes or tax rates
  • Raise transfer payments

When the government decided to purchase additional limousines, this was an increase in government spending. When they lowered the tax rate, this put more money in Larry's pocket, and he increased his consumption. Finally, when the government raised the amount of transfer payments, this put additional money in Natalie's pocket and enabled her to increase consumption. As you can see, each one of these fiscal policy actions increased aggregate demand and increased economic output, helping to offset the recession.

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