Question

Discuss some of the challenges associated with expansionary fiscal policy. Your answer should not less than 400 words.

Answer 1

Answer:-

The expansionary fiscal policy will lead to increase in government’s budget deficit. This is a potential problem of expansionary fiscal policy. Higher borrowing cause markets to fear default and push up interest rates on government debt.

An expansionary fiscal policy may end up decreasing aggregate demand because of crowding-out effect. Increased government borrowing leads to an increase in interest rates, which leads to a decrease in aggregate demand.

What happens to aggregate supply and aggregate demand with these expectations of expansionary fiscal policy:

a) When expansionary fiscal policy comes out as a surprise, aggregate demand will increase. Consumption will increase, shifting the aggregate demand curve to the right. This will result in increased prices and output.

b) When expansionary fiscal policy is fully anticipated, consumers are well prepared for the increased government expenditures and plan their expenses and consumption in advance. There will be no rapid increase in consumption. Consumption will increase, but very minimally, with no drastic change in any variable.

c)

With an expansionary policy which falls short of the expectations. AD will fall, as the planned consumption of households will not get satisfied. Price level will fall along with the output, leading to recession.

d)

With an expansionary policy which is much more than the consumers' expectations, AD will increase drastically, as the consumers will be left with higher disposable income. Price level will rise along with the output, leading to inflation.