Fiscal Policy

TYS 2023 6a

Explain why expansionary fiscal policy designed to achieve economic growth or lower unemployment may lead to undesirable consequences. [10] 

Introduction 

In an economy, the government has the desire to fulfill all 4 macroeconomic goals. These goals are: economic growth, low and stable rate of inflation, low unemployment rate as well as a healthy balance of trade. Expansionary fiscal policy can achieve economic growth or lower unemployment through increasing government expenditure and/or reducing taxes. However, this may lead to undesirable consequences as it will result in a conflict between the 4 macroeconomic goals. Other issues regarding budget availability may also arise.  

R1: Explain how expansionary fiscal policy works and its trade offs with Inflation

 Expansionary fiscal policy works by increasing government spending (G) or reducing taxes (T). Since government spending directly contributes to aggregate demand (AD = C + I + G + (X-M)), higher G raises AD. Reductions in personal income tax increase disposable income, enhancing consumers’ purchasing power and thus consumption (C). Similarly, cutting corporate taxes boosts after-tax profits, encouraging firms to undertake additional investments (I). Together, these measures significantly raise AD.

As government spending (G), consumption (C), or investment (I) increases, aggregate demand (AD) rises, leading to an increase in national income (Y). With higher income, households experience increased disposable income and purchasing power, prompting higher consumption spending. This induced consumption further boosts AD, resulting in subsequent rounds of income increases. However, each round sees a smaller rise in consumption because some income is withdrawn through savings, taxes, and imports. This cycle repeats until the incremental rise in consumption becomes negligible. Through this multiplier effect, national income ultimately increases by more than the initial spending injection. Graphically, AD shifts rightward from AD₀ to AD₂, leading to a rise in real output from Y₁ to Y₂, thus achieving economic growth and reducing unemployment.

Nevertheless, this policy can lead to undesirable outcomes, specifically demand-pull inflation. As the economy nears full employment, resources like labour, land, and capital become increasingly scarce. Firms compete intensely for these limited resources, causing production costs and the general price level (GPL) to rise, shown graphically as an increase from P₁ to P₂ when AD moves from AD0 to AD₂. This overheating economy leads to inflation, which is undesirable as it erodes the real value of money and purchasing power. Consequently, material standards of living (mSOL) decline as consumers can afford fewer and lower-quality goods and services, illustrating a direct conflict between achieving low inflation and stimulating growth or reducing unemployment.

R2: Explain how expansionary fiscal policy might conflict with fiscal sustainability and  sustainable economic growth 

Expansionary fiscal policy, which involves increasing government spending (G) and/or reducing taxes (T) to stimulate aggregate demand (AD), may conflict with the objective of sustainable economic growth. This is because such policies often result in significant budget deficits that must be financed through either borrowing or drawing down national reserves—both of which impose long-term fiscal burdens. Borrowing adds to the national debt, requiring future repayments with interest, while using up reserves reduces a government’s capacity to cushion against future economic shocks such as financial crises or pandemics.

Over time, governments facing rising debt levels may be forced to restore fiscal discipline and sustainability through fiscal austerity—defined as a series of policy measures aimed at reducing budget deficits by cutting public expenditure and/or raising taxes. This diverts resources away from long-term, productivity-enhancing investments in areas such as infrastructure, education, and healthcare, thereby weakening the foundations for future growth. Moreover, the need to raise taxes or cut essential services can lower households’ disposable income and firms’ profitability, reducing consumption (C) and investment (I). This results in a fall in AD and national income (Y), lowering material standard of living (mSOL) and impeding sustained growth.

This trade-off is evident in the case of Greece during the Eurozone crisis, where years of expansionary spending followed by large budget deficits necessitated severe austerity measures. These included drastic cuts to social spending and public sector wages, alongside tax hikes, which plunged the economy into a prolonged recession, exacerbated unemployment, and triggered widespread social unrest. Hence, while expansionary fiscal policy may deliver short-term benefits, it can undermine sustainable growth if not carefully managed within a prudent fiscal framework.

Conclusion 

Expansionary fiscal policy, while effective in stimulating economic growth or reducing unemployment in the short term, may lead to inflationary pressures, sustainability issues, and conflicts among macroeconomic goals. Thus, its use must be carefully considered based on the specific economic context and challenges faced.