Question

Q1) Explain the difference between contractionary and expansionary fiscal policy. Regarding the business cycle, when would you use each type of fiscal policy? Explain you answer with sufficient detail so the instructor has clear evidence that you under the difference between the policies, the types of action each policy might entail, and the economic impact of each.

Answer 1

Fiscal policy can be defined as the action of the government to manipulate the output and price in the economy by using the taxes and government expenditure as the tool.

Contractionary fiscal policy involves increasing the tax and decreasing the government expenditure. The governments adopt these policies when the economy is facing a high demand and reaching its potential output or going beyond it. The contractionary fiscal policy can reduce the aggregate demand and check the inflation in the economy.

An expansionary fiscal policy is a situation when the economy is facing a low output and high unemployment and business sentiments are down in the economy. IN such a scenario cutting taxes and increasing the government expenditure will increase the aggregate demand in the economy. It will also help the economy reach its potential output level and increase the employment in the economy.