Question

a) Define what are expansionary and contractionary discretionary fiscal policies.

b) Define what is automatic stabiliser in fiscal policy and provide 2 examples.

c) Consider an economy that is operating below the full-employment level of GDP, what would be the effect of an increase in government spending on agreegated demand and real GDP.

Answer 1

a) Expansionary fiscal policy is when the government expands the money supply in the economy using budgetary tools to either increase spending or cut taxes—both of which provide consumers and businesses with more money to spend. It seeks to encourage economic growth and is intended to prevent or moderate economic downturns and recessions by boosting business investment and consumer spending.

Contractionary fiscal policy is when the government either cuts spending or raises taxes. These policies siphon money from the private economy, with hopes of slowing down unsustainable production or lowering asset prices and in order to fight inflationary pressures.

b)

It shall be noted that Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation's economic activity through their normal operation without additional, timely authorization by the government or policymakers. They intended to stabilize incomes, consumption, and business spending over the business cycle and combat economic slumps and recessions.

Examples are:

1)  progressively graduated corporate and personal income taxes

2) transfer systems such as unemployment insurance and welfare

c)

Effect of government spending on aggregate demand and real GDP:

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term. However, the effect would depend on the state of the economy.

As can be observed in the diagram above, if the economy is close to full capacity, then higher government spending may cause inflationary pressures and little increase in real GDP. If the economy is in recession, and the government borrows from the private sector, it can act as an expansionary fiscal policy to boost economic growth.