Expansionary Fiscal Policy: Definition, Examples

What Sets Bush and Obama Apart From Clinton

expansionary monetary policy
President Barack Obama extends his hand to former President George W. Bush (C) as former President Bill Clinton (L) looks on in the Rose Garden of the White House January 16, 2010. Photo by Mark Wilson/Getty Images

Definition: Expansionary fiscal policy is when the government uses its budgeting tools to add capital to the economy. These tools are either increased spending or tax cuts. They provide consumers and businesses with more money to spend. In the United States, Congress must approve these measures.

To increase spending, the government can increase discretionary spending, including military expenditures.

 It can also raise payments in mandatory programs such as Social Security, Medicare or welfare programs. Sometimes these payments are called transfer payments because they reallocate funds from taxpayers to targeted demographic groups. For example, one transfer payment that's not a mandatory program is expanded unemployment benefits.

The government has many tax cuts to choose from. They include taxes on income, capital gains and dividends. It can also cut small business, payroll and corporate taxes. 

Purpose

The purpose of an expansionary fiscal policy is to boost growth to a healthy economic level during the contractionary phase of the business cycle. The government wants to reduce unemployment, increase consumer demand and avoid a recession. If a recession has already occurred, then it seeks to end the recession and prevent a depression

How It Works

Expansionary fiscal policy gets its name from the way it expands the amount of money available for consumers and businesses to spend.

It puts more money into consumers' hands to give them more purchasing power. It uses subsidies, transfer payments including welfare programs and income tax cuts. It reduces unemployment by contracting public works or hiring new government workers. All these measures increase demand, which boosts businesses’ profits.

They use it for new investment and hiring to meet the greater demand. For more, see Do Tax Cuts Create Jobs?

The government also puts more money into businesses' hands. The theory of supply-side economics recommends lowering corporate taxes instead of income taxes. That gives companies funds to hire more workers. It advocates lower capital gains taxes to increase business investment. But, this type of trickle-down economics doesn't work unless tax rates are already 50 percent or higher. For more, see What Does the Laffer Curve Really Say?

Examples

The Obama administration used expansionary policy with the Economic Stimulus Act. The ARRA cut taxes, extended unemployment benefits and funded public works projects. In 2010, he continued many of these benefits with the Obama tax cuts. He also increased defense spending. All this occurred while tax receipts dropped thanks to the 2008 financial crisis. That's why the national debt increased so much under Obama.

The Bush Administration correctly used expansive fiscal policy to end the 2001 recession. It cut income taxes with EGTRRA, which mailed out tax rebates. But the 9/11 terrorist attacks sent the economy back into a downturn. Bush boosted government defense spending with the War on Terror.

He cut business taxes in 2003 with JGTRRA. By 2004, the economy was in good shape, with unemployment at just 5.4 percent. But Bush continued expansionary policy, boosting defense spending with the War in Iraq.

President John F. Kennedy used expansionary policy to stimulate the economy out of the 1960 recession. He was one of the first advocates of sustaining the policy until the recession was over, regardless of the impact on the debt.

President Franklin D. Roosevelt used expansionary policy to end the Great Depression. At first, it was working. But he cut back spending on the New Deal in response to pressure to cut the debt. As a result, the Depression reappeared in 1932. FDR returned to expansionary policy to gear up for World War II. That massive spending finally ended the Depression.

For more examples, see:

Pros

Expansionary fiscal policy works fast because it puts money into the hands of consumers. It create jobs and immediately lowers unemployment. Most important, it restores consumer and business confidence. That's critical for them to start spending again. Without confidence, a recession could turn into a depression. Everyone would just stuff their money under their mattress.

Cons

Tax cuts decrease government revenue. That creates a budget deficit and adds to the debt. The tax cuts must be reversed when the economy recovers to pay down the debt. Otherwise, it grows to unsustainable levels. But, reversing tax cuts is often an unpopular political move.

The U.S. federal government has no limitation because it prints money. It can pay for the deficit by issuing new Treasury bills, notes and bonds. As a result, the national debt is almost $20 trillion. That's more than the country produces in a year. For more, see Debt to GDP Ratio.

Politicians often use expansionary fiscal policy for reasons other than its real purpose. For example, they might cut taxes to become more popular with voters before an election. That sets up a dangerous situation because they will get voted out of office if the tax cuts are reversed.

The government often increasing spending and lowers taxes even when the economy is doing fine. That creates asset bubbles that lead to irrational exuberance and the peak phase of the business cycle. When the bubble bursts, you get contraction and recession. For more on how this works, see What Causes the Boom and Bust Cycle?

Expansionary vs. Contractionary Fiscal Policy

Expansionary policy is used more often than its opposite, contractionary fiscal policy. That's because voters like both tax cuts and more benefits. Therefore, politicians that implement expansionary policy get re-elected. 

State and local governments in the United States have balanced budget laws. They cannot spend more than they receive in taxes. That's a good discipline, but it also reduces lawmakers' ability to boost economic growth in a recession.  If they don't have a surplus on hand, they have to cut spending when tax revenues are lower. That makes the recession worse.

Expansionary Fiscal Policy vs. Expansionary Monetary Policy

Expansionary monetary policy is when a nation's central bank increases the money supply. It adds more liquidity in a recession. Central banks can also implement contractionary monetary policy, which raises rates and prevents inflation. The long-term impact of inflation can damage the standard of living as much as a recession.

Monetary policy works faster than fiscal policy. The Federal Reserve votes to raise or lower the fed funds rates at its regular FOMC meetings. It may take about six months for the effect to percolate throughout the economy.

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