Essay Example on Expansionary and Contractionary Fiscal Policies

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The main changes in expansionary fiscal policy are increasing governments spending and lowering tax. Apparently, higher government spending increases aggregate demand leading to a higher economic growth. Similarly, lower taxes increase disposable income among consumers, which rises their spending. Consequently, this increases aggregate demand leading to a higher growth in the economy.

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On the other hand, contractionary fiscal policy involves the governments attempts to lower aggregate demand. The primary changes include lowering its spending and increasing taxes. Both attempts reduce spending on goods and services, which lowers the aggregate demand.

The government uses expansionary fiscal policies to respond to unemployment caused by recession. It does this by cutting taxes, which increases the aggregate demand and the rate of economic growth. In the short-run, lower taxes makes firms increase their production, which calls for additional labour. Consequently, an increase in the jobs leads to lower unemployment. In the long-run, with high aggregate demand and a strong economic growth, fewer firms will go bankrupt. Therefore, the unemployment levels will remain low.


Crowding refers to the decline in private spending because of the rise in interest rates following the use of expansionary fiscal policy. As the government borrows more from the private investors with the aim to increase its spending, it increases its deficit.

When the supply of loanable funds is high, then the aggregate demand declines as the market becomes flooded with more products and services. Nevertheless, when the supply is low, the aggregate demand increases as fewer firms produce goods following lack of funds to produce. Therefore, the expansionary fiscal policies are most effective when the supply curve is steep.

When the interest rates are high, the rate of investment declines. However, the level of investment increases when the interest rates decline. The expansionary fiscal policies are effective when the investment demand curve is steep as shown in the graph below.

If the government cuts the taxes but people see that this act is temporary, they will be inclined to spend less money. Therefore, the aggregate demand will decline. Consequently, this will lower the effectiveness of the expansionary fiscal policy.

Keynesian Model

This model is most descriptive of an economy in the short run when aggregate prices are inflexible. Under these conditions, an increase in autonomous expenditures is essentially converted to a rise in output. Contrary to this, the model avails poor estimates of long run relationships when prices have time to adjust. Therefore, the increase in autonomous expenditure, holding other things constant, results in a higher aggregate price level.

Severity of national debt

1995 severity

9004500=0.21996 severity

9404700=0.2The severity of the debt did not change from 1995 to 1996.

1997 severity

9704900=0.198The severity of the debt reduced from 1996 to 1997.

A deficit results when the government spends more that it receives. On the other hand, the government debt is the cumulative money the government has had to borrow over the years. A deficit always increases the severity of a governments debt. Moreover, the deficit increases the national debt.

Less long-term economic growth

In the long-term, expansionary fiscal policies will lead to three effects that will lead to a lower long-term economic growth. These impacts include decreased private investment, decreased net exports, and increased inflation since increasing the capital in the system will eventually devalue the currency.

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