Question

Explain how, under certain conditions, expansionary fiscal policy can destabilize the economy.

Short answer

An expansionary fiscal policy, consisting of increased government spending and reduced taxes, can destabilize the economy when it induces inflation due to demand-pull effect or when it crowds out investment by increasing interest rates. Moreover, an excessive stimulus can push the economy past its long-term trend line leading to a boom-bust cycle.

Step-by-step solution

Understand Expansionary Fiscal Policy

Expansionary fiscal policy is a type of fiscal policy that involves increasing government expenditures, decreasing taxes, or both, in order to stimulate economic growth or fight off recessionary pressures.

Understand Economic Stability

Economic stability refers to an economy that experiences constant growth and low inflation or deflation. Destabilize thus implies that these results are not produced, causing things like erratic growth, high inflation, deflation, high unemployment, etc.

Illustrate How the Policy Can Destabilize the Economy

By increasing government spending or decreasing taxes, expansionary fiscal policy boosts production and employment, and thus increases income and consumer spending. This leads to increased demand. However, if the economy is already close to full employment, this demand-pull can lead to inflationary pressures as businesses raise prices. The increased borrowing by the government to finance its expenditures can also crowd out investment by increasing interest rates (crowding out effect). Both cases cause destabilization. Another scenario is the overshooting scenario, where stimulus leads the economy past its long-term trend line causing a boom-bust cycle.