Expansionary Fiscal Policy
Fiscal Policy refers to the federal government use of spending and taxation to meet the macroeconomics goals. At the time of recessionary periods, the federal government, in order to smooth the economic cycles, reduce the taxes and increase the government spending g. Important to note that each of these measures has an important effect on the aggregated demand, GDP and employment and the same is discussed below:
Effect of reduced rates of Taxes:
As a general phenomenon, income taxes reduce the incentive to work by creating a tax wedge between pre-tax and after-tax wages. Thus, at the time of the recessionary period, the federal government in order to stimulate the economic functioning reduces the income taxes which increase the after-tax wages of the labor. As a result, workers will be likely to work for increased number of hours as they did when their after-tax wages were lower. Thus, as tax rates are reduced, the full-employment supply of labor increases, which increases the potential GDP. The diagram below indicates the effect of reduced tax rates on the potential GDP of the economy:
Real GDP Production Function
The diagram above indicates the link between the tax rates and real GDP. The reduction in tax rates as the part of expansionary fiscal policy will cause the labor supply curve to shift to the right to SAT, which reflects the increase in after tax income of the labor. As a result, there is an increase in equilibrium quantity of labor from LBT to LAT and consequently real GDP increases as a result of the increase in the equilibrium quantity of labor.
Following the decrease in taxation rates, the economy also witnesses an increase in aggregate demand and employment figures. For Instance, a decrease in taxation rates, increase the level of disposable income in the hands of labor that consequently increase the consumption expenditure and thereby increases the aggregate demand in the economy. This enhances the sales and profit figures of the corporations, which induces them to increase the production levels which are met by adding more labor force. As a result, the reduction in taxation rates as a part of expansionary fiscal policy results in the triple effect of increased GDP levels, employment figures and aggregate demand.
Effect of Increased Government Spending:
Similarly, during recessions, actions can also be taken to increase the government spending when economic growth slows. The government spending can be in the form of new development projects, completion of pending projects, etc. As a part of this policy, new labor opportunities are created, and this lowers the unemployment figures. Subsequently, with higher employment figures, the level of disposable income also increases which lead to increased aggregate demand in the economy.
Combined Effect of reduced tax rates and increased government spending on aggregate demand:
Important to note that although, increase in government expenditure and reduction in taxation rates has a magnified effect on the aggregate demand; however, if the government spending is increased it will have a larger effect on the aggregate demand than the reduced taxation rates. This is because the increase in government spending generates additional income, which leads to increased consumption expenditure and investment, which in turn further increases aggregate demand and income. Hence, the effect of increased government expenditure is more than the reduced taxation rates, which is also known as Government Expenditure Multiplier.
Expansionary Monetary Policy
i) Effect of Buying or Selling government securities:
Popularly known as ‘Open market operations, or Quantitative Easing,’ these methods of monetary policy of the Fed are the most widely used to promote economic stimulus. Just as any other methods of monetary policy, even open market operations have a significant effect on the money supply, interest rates, spending, aggregate demand, GDP, and employment. For Instance, at the time of recessionary period, The Fed engages in open market purchase of Treasury Securities, which increase the money supply in the economy and the bank reserves. Excess reserves lead to decrease in Federal Funds Rate (FFR) as banks are now more willing to lend reserves to each other. Thus, following the excess supply of loanable funds in the economy, the interest rate falls as banks have more reserves and are more willing to make loans to consumers and businesses.
S’ S(after purchases)
Quantity of Money
The decrease in rates on business loans causes businesses to find borrowing to fund expansion more attractive and spend more on investment in plant and equipment. Similarly, the consumers also react to a reduction in the interest rates on consumer loans by increasing their purchase of goods that are typically financed such as houses, automobiles and appliances. In sum, following the purchase of treasury securities in the open market and the resultant increase in money supply/fall in the interest rates; increases the business investment, consumer purchases, thus tending to inflate the aggregate demand in the economy. Subsequent to the increase in the aggregate demand, an upward pressure is built in the price levels, inducing producers to supply more quantity. This links to addition of more labor force (higher employment), resulting in an increase of real GDP.
A vice-versa effect is witnessed when in order to curb the inflation evil, Fed decides to sell the treasury securities which create leakage in the loanable funds market and the total money supply is reduced in the economy. This increases the equilibrium interest rates which results in decreased aggregate demand and reduced GDP levels.
ii) Effect of Change in required reserve ratio:
Reserve requirement is the mandatory reserves to be created by the banks of the percentage specified by the Federal Bank. These reserves are meant for the purpose of backing up the deposits held by the banks and to ensure that the bank maintain enough liquidity so as to avoid any sort of bank panics and other problems created when banks run short of reserves. In general, these requirements are in the range of 10% of the current/checkable deposits and 0% of the saving deposits. In many countries, this is also known as ‘’Cash Reserve Ratio’’.
Important to note that Fed use reserve requirements so as to maintain economic stimulus. For Instance, at the time of the recessionary period, Fed decreases the reserve requirements for the commercial banks which result in additional loanable funds available with the banks. In other words, the money supply increases in the economy and with banks ready to lend these additional funds to the consumers and businesses, an increase in supply of loanable funds takes place that reduces the interest rates in the economy. The decrease in the interest rates induces the businesses and consumers to borrow more funds, and this produces multiple effects in the form of increased aggregate demand, more employment and higher GDP levels. For Instance, with low interest rates prevailing, businesses add more projects, and this creates new employment opportunities and a resultant increase in aggregate demand because of the increase in income of the newly employed labor. On the other hand, consumers react to low interest rates with additional borrowing for purchasing new homes(remember in 2006, every American was induced to purchase new and bigger homes because of extremely low mortgage rates) or basic appliances. Overall, the economy witness increased aggregate demand and as we have already discussed this puts upward pressure on price levels and real GDP.
At time of inflation, a vice-versa effect is witnessed with Fed increasing the reserve requirements which results in the decrease in money supply and increase in interest rates which subsequently decrease the borrowing by businesses and consumers, resulting in lower employment and decreased aggregate demand and reduced GDP levels.
iii) Effect of Change in Discount Rates:
Also known as Bank Rate, the discount rate is the rate at which the Federal Reserve Bank lends loan to the commercial banks. In other words, the discount rate is the rate which the commercial banks pay as interest to Federal Reserves and at the same is used as a tool to control the money supply in the economy. For Instance, at the time of recessionary periods, Federal Reserve in order to promote the economic stimulus, reduce the discount rates at which it will lend the funds to the commercial banks. This creates an incentive for the commercial banks to borrow more from the Federal Reserve, which results in additional money supply in the economy. Courtesy increased supply of loanable funds in the market, the economy witness decrease in the equilibrium interest rates which further induces the businesses and consumers to borrow funds for their business expansion and related purchases, respectively. While the additional borrowing by the businesses is diverted towards business expansion, consumers, on the other hand, accept borrowing for purchasing home, automobiles, etc. In sum, the fall in equilibrium interest rate leads to increase in the aggregate demand in the economy. Furthermore, the increase in aggregate demand is well supported by higher employment and increased GDP levels.
At times of inflation, a vice-versa effect is experienced by the economy as in order to reduce the effect of inflation, Federal Reserve increase the discount rates for the banks which reduces the incentive for the commercial banks to borrow funds from the Federal Reserve. This leads to decrease in the money supply in the market and higher equilibrium interest rates, resulting in low borrowings by the businesses and consumers, leading to fall in aggregate demand, price levels and real GDP.
Expansionary Moentray Policy. (n.d.). Retrieved June 20, 2014, from http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=expansionary+monetary+policy
Fiscal Policy. (n.d.). Retrieved June 20, 2014, from Investopedia: http://www.investopedia.com/terms/f/fiscalpolicy.asp
Parkin, M. (2011). Monetary Policy. In C. Institute, Economics (pp. 230-241). Boston: Custom.