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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 11ís 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.


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