What Does Expansionary Fiscal Policy Do?

Expansionary fiscal policy involves government actions to increase the money supply and stimulate economic growth, especially during recessions. It aims to boost overall demand for goods and services, encouraging businesses to produce more and hire additional workers.

The Tools of Expansionary Fiscal Policy

Expansionary fiscal policy primarily uses two main instruments: increased government spending and tax reductions.

Increased government spending involves directly injecting funds into various economic sectors. This includes funding large-scale infrastructure projects, such as those authorized by the Infrastructure Investment and Jobs Act, which provided approximately $1.2 trillion in federal funds. It also covers investments in public services or direct payments to individuals, like unemployment benefits or stimulus checks.

Tax reductions lower the rates at which individuals and businesses are taxed, leaving more money in their hands. This includes cuts to income, corporate, or sales taxes. For example, the Tax Cuts and Jobs Act reduced tax rates for both corporations and individuals. The recent “One Big Beautiful Bill Act,” signed in July 2025, extended many of these provisions and introduced new tax breaks, such as a temporary increase in the State and Local Tax (SALT) deduction cap from $10,000 to $40,000 for tax years 2025 through 2029.

How It Drives Economic Activity

Expansionary fiscal policy drives economic activity by directly influencing aggregate demand, which is the total demand for all goods and services in an economy. Both increased government spending and tax reductions boost this overall demand.

When the government increases spending, it directly adds to the demand for goods and services. Federal contracts for new infrastructure projects, for instance, create demand for materials, equipment, and labor. This injection of money stimulates production as businesses respond. Direct payments to individuals, like unemployment benefits, also enable consumers to purchase more, further increasing demand.

Tax cuts increase the disposable income available to individuals and businesses. With more take-home pay, individuals tend to increase consumption and savings. Businesses, facing lower corporate tax burdens, may invest more in new equipment, facilities, or expansion, leading to increased production and hiring.

This initial increase in spending or investment triggers a ripple effect known as the multiplier effect. This effect shows how an initial injection of money leads to a larger overall increase in economic activity. For example, when the government spends on an infrastructure project, that money becomes income for workers. They then spend a portion, which becomes income for others, and so on. This continuous circulation amplifies the initial spending or tax cut, leading to a greater total increase in economic output.

Influence on Key Economic Indicators

Expansionary fiscal policy influences several key macroeconomic indicators.

Gross Domestic Product (GDP), which measures a nation’s total output of goods and services, increases under expansionary fiscal policy. The rise in aggregate demand, fueled by government spending and consumer/business activity from tax cuts, encourages businesses to increase production. This higher production directly contributes to a larger GDP.

Employment levels also increase as businesses expand operations to meet heightened demand. When companies produce more, they hire additional workers, reducing unemployment rates. Large-scale infrastructure projects, for instance, require a substantial workforce, creating numerous job opportunities.

Price levels, or inflation, experience upward pressure due to increased aggregate demand relative to supply. If demand outpaces the economy’s ability to produce, businesses may raise prices. This means the policy, while stimulating growth, can also lead to a general rise in the cost of living.

Interest rates are affected as the government often finances increased spending or compensates for reduced tax revenue by borrowing more. This increased demand for loanable funds puts upward pressure on interest rates. Higher interest rates influence the cost of borrowing for businesses and consumers, affecting investment and purchasing decisions.