Question

Briefly explain how an expansionary fiscal policy will cause each of the following variables to increase or decrease. a. Real GDP b. The unemployment rate c. The price level

Short answer

Expansionary fiscal policy, involving increased government spending or decreased taxes, boosts demand in the economy. This helps increase Real GDP as firms amp up production to meet the demand. It also leads to a decrease in the unemployment rate as more labor is required to meet the increased production. However, the increased demand can cause a rise in the price level as businesses have more leeway to increase prices and as scarce resources for production become more expensive.

Step-by-step solution

Impact on Real GDP

When the government increases spending or decreases taxes, it stimulates greater demand in the economy. Households have more disposable income to spend due to tax cuts while increased government spending results in more contracts for businesses. Both effects lead to a higher demand for goods and services, which in turn prompts firms to increase their production. This increased production results in a rise in Real GDP.

Impact on the Unemployment Rate

The increase in demand due to expansionary fiscal policy not only boosts production but also necessitates firms to increase their workforce to meet rising demand. This increased demand for labor lowers the unemployment rate, as more people are hired to meet the increased demand.

Impact on the Price Level

As demand for goods and services increases due to expansionary fiscal policy measures, businesses may find they can increase their prices. This is because with more people having greater disposable income, consumers are willing to pay more for goods and services. Similarly, increased demand may result in businesses bidding up the prices of scarce resources needed for production. Both these factors result in a rise in the overall price level of the economy.

Key concepts

Real GDP

Expansionary fiscal policy is a powerful tool for influencing the overall economic activity, particularly the Real Gross Domestic Product (Real GDP). Real GDP represents the total value of goods and services produced within a country, adjusted for price changes. When the government implements expansionary fiscal policy, such as increasing its spending or reducing taxes, it injects additional funds into the economy. This leads to several knock-on effects.

Firstly, households experience a rise in disposable income, either directly through lower taxes or indirectly due to increased opportunities for employment from government projects. Businesses benefiting from government contracts also contribute to economic demand and may expand their operations. Collectively, these actions boost production to meet heightened demand, thereby elevating Real GDP. It's a clear example of how targeted policy adjustments can stimulate economic growth, as measured by increased output of goods and services.

Unemployment Rate

Regarding the unemployment rate, expansionary fiscal policy can be a boon for job seekers. A lower unemployment rate is both a goal and a consequence of such policy. As the government spends more or decreases taxes, this stimulates economic demand, which in turn increases production. Increased production requires more hands on deck, prompting firms to embark on a hiring spree.

This surge in employment opportunities thus decreases the unemployment rate. It's important to understand the direct relationship between economic stimulus and job creation. When more people are employed, they also contribute to the economy by spending their income, creating a virtuous cycle that further reduces unemployment.

Price Level

The price level in an economy is essentially a measure of the aggregate prices of goods and services. Expansionary fiscal policy influences the price level by altering the balance of supply and demand. Specifically, as the fiscal policy boosts demand—thanks to higher government spending and increased take-home pay for consumers—businesses may respond to this larger customer base by raising prices.

This is partly because consumers with more disposable income are typically willing to pay more, and partly because greater demand could lead to a scarcity of resources, driving up costs for production. The outcome is an increase in the price level, which is inflationary in nature. It highlights the careful balancing act required in policy-making to stimulate growth without causing excessive inflation.

Government Spending

Government spending is a pivotal factor in an expansionary fiscal policy. It refers to how much a government budgets for expenditures on various public services, infrastructure projects, and social programs. By heightening its expenditure, the government intends to stimulate economic demand directly.

This injection of public funds can take the shape of new highways, healthcare spending, or educational grants, which have two-fold benefits. They create jobs and income for individuals, who then have more resources to spend in the economy. Such spending also lays the groundwork for long-term economic growth by improving the nation's infrastructure and workforce. Hence, government spending not only serves immediate economic stimulus goals but can also enhance future productivity.

Economic Demand

Lastly, economic demand is a crucial element anchoring the concepts of expansionary fiscal policy. It refers to the quantity of goods and services that consumers and businesses are willing to purchase at a given price level. Expansionary fiscal policy boosts economic demand through increased government spending and tax reductions.

When people have more income due to tax cuts, they spend more. Similarly, when the government spends on services and infrastructure, companies benefit from new contracts and hire more workers, who in turn, have more income to spend. This increased spending by both consumers and businesses amplifies economic demand which typically results in a rise in production, pulling along the Real GDP and potentially impacting the price level. Understanding the dynamics of economic demand is central to grasping the overarching effects of fiscal policy on an economy.