Question

Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy?

Short answer

A government might use expansionary fiscal policy in circumstances such as a recession, high unemployment, or deflationary pressures to boost economic growth and reduce unemployment. Contractionary fiscal policy is used when the economy experiences rapid growth, high inflation, or overheating to slow down economic growth, control inflation, and stabilize the economy.

Step-by-step solution

Understanding Expansionary Fiscal Policy

Expansionary fiscal policy is a type of fiscal policy that involves increasing government spending, lowering taxes, or a combination of both to boost economic growth. The objective of this policy is to stimulate aggregate demand, increase output, and reduce unemployment during a recession or economic downturn.

Understanding Contractionary Fiscal Policy

Contractionary fiscal policy, on the other hand, involves decreasing government spending, increasing taxes, or both to slow down economic growth. The main goal of this policy is to decrease inflation, stabilize the economy, and address macroeconomic imbalances during periods of rapid growth or boom.

Application of Expansionary Fiscal Policy

A government might use expansionary fiscal policy under the following macroeconomic circumstances: 1. A recession or economic slowdown: Expansionary policy stimulates aggregate demand, which helps increase overall output and reduce unemployment. This is effective in situations where the economy experiences low growth or negative growth rates. 2. High unemployment: Expansionary fiscal policy can create jobs and lower unemployment levels. Increased government spending on public works projects, for example, can directly create employment opportunities. 3. Deflationary pressures: If an economy faces deflation or persistently low inflation, expansionary fiscal policy can increase demand, resulting in an uptick in the price level.

Application of Contractionary Fiscal Policy

A government might use contractionary fiscal policy under the following macroeconomic circumstances: 1. Rapid economic growth or boom: During periods of high economic growth, inflation can become a concern. Contractionary fiscal policy helps slow down the rate of growth, reducing the risk of inflation and stabilizing the economy. 2. High inflation: If inflation levels are above the desired target range, contractionary fiscal policy, such as increasing taxes or reducing government spending, can help reduce inflationary pressures and bring inflation back to target levels. 3. Overheating economy: If an economy is growing at an unsustainable pace, the government may implement contractionary fiscal measures to prevent it from overheating and to avoid potential financial crises or economic imbalances. In summary, a government might use expansionary fiscal policy when the economy faces a recession, high unemployment, or deflationary pressures. Meanwhile, contractionary fiscal policy is appropriate when the economy experiences rapid growth, high inflation, or overheating.