Question

Show the effects of expansionary fiscal policy (e.g. an increase in government expenditure) on our simultaneous equilibrium in the money and foreign exchange markets. How does the shock originate? What is the ultimate impact on the value of the domestic currency?

Answer 1

Definition of expansionary fiscal policy. This involves the government seeking to increase aggregate demand – through higher government spending and/or lower tax.

Expansionary fiscal policy is usually financed by increased government borrowing – and selling bonds to the private sector.

Keynes said expansionary fiscal policy should be used during a recession – when there is unemployment, surplus saving and falling real output. He argued this injection of government spending could stimulate economic activity and get the unemployed resources back into productive use. This enables the economy to recover more quickly than a laissez-faire approach.

Expansionary Fiscal Policy – AD/AS

Impact of expansionary fiscal policy – increases AD and leads to higher real GDP and inflation.

How expansionary fiscal policy works

If the government cut income tax, then this will increase the disposable income of consumers and enable them to increase spending. Higher consumption will increase aggregate demand and this should lead to higher economic growth.

Alternatively, if the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand.

This injection of money into the economy can also cause a positive multiplier effect. For example, builders who gain a job will also spend more creating jobs elsewhere in the economy. From the government’s initial injection the final increase in real GDP will be more than the initial investment.

Expansionary fiscal policy can also lead to inflation because of the higher demand in the economy.