When Is Expansionary Fiscal Policy Used?

Expansionary fiscal policy involves government actions designed to stimulate economic growth and activity. The overarching goal of this policy approach is to inject money into the economy to encourage spending and investment. It represents a deliberate strategy to influence macroeconomic conditions.

Periods of Economic Contraction

Expansionary fiscal policy is primarily implemented during periods of economic contraction or slowdowns. An economic recession signifies a significant decline in economic activity that spreads across the economy and typically lasts for more than a few months. This downturn is often evident through a decrease in real gross domestic product (GDP), a rise in unemployment, and reduced industrial production.

Rising unemployment rates, declining GDP growth, and a drop in consumer and business confidence signal an economy moving into a recession. A common, though informal, definition of a recession is two consecutive quarters of shrinking GDP. The “Sahm Rule” suggests a recession is likely when the three-month moving average of the national unemployment rate increases by 0.5 percentage points or more relative to its low point in the preceding 12 months.

When actual economic output falls below its potential output, referred to as an “output gap,” it indicates that the economy is underperforming and resources are not being fully utilized. This gap suggests a need for intervention to bring the economy back to its full productive capacity. Governments use expansionary fiscal policy to close this negative output gap and restore economic health.

Addressing Insufficient Aggregate Demand

Expansionary fiscal policy aims to address the fundamental problem of insufficient aggregate demand during economic downturns. Aggregate demand represents the total spending on all final goods and services within an economy. It encompasses consumer spending, business investment, government expenditures, and net exports.

A decline in consumer confidence often leads to reduced spending by households, while businesses may cut back on investments in new equipment or expansion plans. Such decreases in private sector spending contribute to a shortfall in aggregate demand, which can result in job losses and slower economic growth. This creates a downward economic spiral where weak demand further discourages investment.

To counteract this, expansionary fiscal policy directly boosts aggregate demand. Governments can increase their own spending on public projects, such as infrastructure development or social programs, which directly injects money into the economy and creates jobs. Alternatively, tax reductions for individuals and businesses can increase disposable income and profits, encouraging greater consumer spending and business investment.

Complementing Monetary Policy

Expansionary fiscal policy is often used in conjunction with monetary policy to provide a comprehensive response to economic challenges. Monetary policy, managed by central banks, influences economic activity primarily through controlling the money supply and interest rates. While both policies aim to stabilize the economy, their mechanisms differ.

In certain severe economic downturns, monetary policy alone may prove insufficient or less effective. This can occur when interest rates are already very low, approaching zero, a situation sometimes described as a “liquidity trap.”

In such scenarios, fiscal policy becomes particularly important, providing the additional stimulus needed to achieve economic recovery goals. Governments can coordinate their fiscal efforts with the central bank’s monetary actions to deliver a more robust and unified response to a significant economic contraction. This coordination helps ensure that both policy tools work in harmony to support economic growth and stability.