Question

When an economy is already at full employment, what is the outcome of expansionary fiscal policies to employment, inflation, real output, and deficits (assuming no changes in tax rates)?

Answer 1

Since the assumption is that there is no change in tax rate, the expansionary fiscal policy that is being talked about in this case is higher level of government spending.

The impact of expansionary fiscal policy on each of the factors given is provided below -

Employment - Since the economy is already at full employment, there is no impact on the level of employment due to expansionary fiscal policy. Further, in the long-term, if government spending remains elevated and there is crowding out of investment from the private sector, the employment rate might be negatively impacted.

Inflation - When the economy is operating at full employment, the real GDP is equal to the potential GDP. Therefore, if the government pursues expansionary fiscal policy, it is likely that all the increase in government spending translates into higher inflation in the economy. The economy might experience an inflationary gap in such a scenario.

Real Output - There is unlikely to be any change in real output when the economy is operating at full employment and the government pursues expansionary fiscal policies. The impact is only related to higher inflation in goods and services. While nominal GDP can increase, there is little or no impact on real GDP.

Deficits - When the government spending increases (expansionary fiscal policy) with no change in real output (since the economy is already at potential GDP), the tax revenue also remains the same. However, with higher government spending, the deficits increase and the total government debt-to-GDP also trends higher.