Government may change its
expenditures and taxation to achieve particular macroeconomic goals. Fiscal
policy is one of the most important economic tools available to the federal
government.a. Expansionary fiscal policy: policy adopted during
recession, aiming to increase AD through increases in government spending or
decreases in taxes.
b. Contractionary fiscal policy: policy adopted during inflation,
aiming to decrease AD through decreases in government spending or increases
in taxes.
After the second quarter of 2001, the U.S. economy has entered into a
recession phrase. In order to counter the recession, the Bush administration
has started to impose the expansionary fiscal policy. Households got tax
refunds. Government has increased expenditure in various sectors such as
national defense (especially after September 11’s attack).
The effect of expansionary or contractionary fiscal policy will be
multiplied by the multiplier. For example, government has decided to provide
a $40B aid for the airline industry after September 11, 2001. This $40B
increase in government spending will increase the aggregate expenditure by
$100B (for M = 2.5). However, the effect of fiscal policy is limited by
certain factors: such as the crowding out effect, foreign loanable funds
effect and time lag problems.
Crowding out effect:Crowding out effect is quite important
because it can completely erase fiscal policy's intention to correct the
market. As the government tried to spend more to correct the recessionary
gap in our economy, they compete with private sector for resources and
goods and services. As government expenditure increases, consumption and
investment decreases, causing the ineffectiveness of the fiscal policy. On
the other hand, in the expansionary fiscal policy, government increases
spending and reduces taxation, most likely result in a deficit which must
be funded through borrowing. This increased borrowing will push the
interest rate higher, reducing the consumption and investment in the
private sector.
