Expansionary Fiscal Policy
What is Expansionary Fiscal Policy?
Expansionary fiscal policy is an increase in government spending or a cut in taxes used to boost aggregate demand in a recession.
It shifts aggregate demand right, raising real GDP and lowering unemployment, often at the cost of higher prices and a larger budget deficit. It is most appropriate during a recessionary gap. Its impact can be weakened by crowding out and time lags.
Expansionary Fiscal Policy: a worked example
Compare two packages of identical size in an economy with an MPC of 0.75. The spending multiplier is 1 ÷ (1 − 0.75) = 4 and the tax multiplier is 0.75 ÷ 0.25 = 3. A $50 billion rise in government purchases shifts aggregate demand right by 4 × $50 billion = $200 billion. A $50 billion tax cut shifts aggregate demand right by only 3 × $50 billion = $150 billion, because households save 0.25 × $50 billion = $12.5 billion of the cut in the first round and just $37.5 billion enters the spending stream. The horizontal shift is not the finish line. If short run aggregate supply slopes upward, the price level rises as output expands, so real GDP grows by less than $200 billion and the remainder of the shift shows up as a higher price level.
The mistake students make with expansionary fiscal policy
After shifting aggregate demand right by the full multiplier amount, students report that real GDP rose by exactly that horizontal distance. The arithmetic is seductive because the multiplier hands over one clean number. That number measures the shift of the curve, not the change in equilibrium output. Along an upward sloping short run aggregate supply curve, the new equilibrium sits above and to the left of the shifted point, so part of the stimulus is absorbed by a higher price level. Only in the horizontal range does output rise by the whole shift.
Expansionary Fiscal Policy questions
When is expansionary fiscal policy appropriate?
Expansionary fiscal policy fits a recessionary gap, meaning real GDP below potential and unemployment above the natural rate. Cyclical unemployment is the target, since stronger aggregate demand puts idle workers and idle factories back to work. Using it when the economy already produces at potential mostly raises the price level rather than output, and it worsens the budget balance at the point in the cycle when tax receipts are strongest.
Does expansionary fiscal policy cause inflation?
Higher aggregate demand raises the price level whenever short run aggregate supply slopes upward, so some inflation usually travels with the extra output. The closer the economy is to full employment, the larger the share of the stimulus that arrives as prices rather than as real GDP. In a deep downturn with idle capacity, the price effect is small and most of the shift becomes real output.
Why is a tax cut weaker than an equal increase in government spending?
Government purchases enter the spending stream in full, while a tax cut first passes through households who save a portion of it. With an MPC of 0.9, a dollar of purchases injects a full dollar, but a dollar of tax cut injects only 90 cents in the first round. In the simple multiplier model AP uses, that gap puts the tax multiplier exactly one below the spending multiplier, since MPC ÷ (1 − MPC) and 1 ÷ (1 − MPC) differ by one.
Formula / Example
This is the live Fiscal Policy sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated