Question

define expansionary fiscal policy and explain:

(1) when the government uses expansionary fiscal policy, (2) its possible negative impacts (3) why it doesn't always work as intended, and (4) why it sometimes can be destabilizing for the economy.

Answer 1

Expansionary fiscal policy refers to the government policy that stimulates the economic activities and works to increase the aggregate demand. As a part of the expansionary fiscal policy, the government increases the spending or reduce the tax. These initiatives, have multiplier effects and is translated to increase the aggregate demand. To cater the increase in demand, the supply increases and new jobs are created. Though, it has the possible negative impact also. One negative impact is the crowding out effect that takes place when increased level of government spending, sucks the money and interest rate rises when firms want to spend. Here, increase in interest rate becomes discouragement to them and government spending does crowding out to the private sector investment. So, the benefits gained from government spending is the offset by the less spending by the private sector. As a result the required production capabilities to cater the increased level of demand is not created. The second negative impact is the increase in inflation rate due to lack of capabilities in the economy.
The expansionary fiscal policy does not work as planned, because there is an inside and an outside lag effects. As inside lag, it takes time to the government to recognize the economic problem, and as per the outside lag, it takes time to reflect the impact of the policy initiatives. It increases the length of time of the effects to be shown by the policy. As a result, the policy becomes less effective.
It is sometimes destabilizing as it is an interference by the government and it discourages the private sector spending as crowd out effect. It causes the increase in aggregate demand, but adequate supply is not present. As a result, the government has to go to the imports to meet the domestic demand. It is destabilizing in nature.