Here, we will differentiate between the two types of fiscal policy:
- Expansionary Fiscal Policy
- Contractionary Fiscal Policy
Expansionary Fiscal Policy
Expansionary Fiscal Policy
Fiscal policy aimed at increasing aggregate demand by increasing government spending and/or reducing (business and personal) taxes.
Expansionary fiscal policies are used to close deflationary gaps by increasing aggregate demand.
- Observing the diagram above, the economy initially produces at $Y_{rec}$ with $AD_1$, below potential output as $Y_{rec}<Y_p$.
- The government can enact expansionary fiscal policies, such as:
- increase government spending (↑G)
- decrease income taxes (causing increase in consumer spending).
- decrease in corporate tax (causing increase in business investments).
- This will cause an increase the aggregate demand from $AD_1→AD_2$ .
- As a result, the recessionary gap will be eliminated, and the economy will be producing at $Y_p$.
In the New Classical model, when government uses expansionary fiscal policy (when current output is at LRAS):
- Aggregate demand increases, shifting the curve to the right.
- In the short run, this leads to higher output and lower unemployment.
- However, in the long run, the economy returns to the full employment level of output, and the only effect is a higher price level.
The same effect apples on Keynesian model as well:
When the government uses expansionary fiscal policy, in the Keynesian model:
- The aggregate demand increases, shifting the curve to the right $AD_1→AD_2$
- In the first stage (horizontal section), this leads to higher output without increasing the price level.
- As the economy moves towards the second stage (upward sloping section), output continues to increase, but inflationary pressures begin to rise, causing an increase in price level.
- This can be observed with $AD_3$ and $AD_4$ as both are on the ends of the second stage.
- Once the economy reaches the third stage (vertical section), further increases in aggregate demand only lead to higher prices without increasing output, which can be observed with $AD_5$ and $AD_6$.
The horizontal section of the Keynesian AS curve represents an economy operating below full employment, where there is spare capacity.
The sloping section of the Keynesian AS curve represents an economy operating below full employment, where there is spare capacity, but the resources are becoming scarce, leading to higher costs.
The vertical section of the Keynesian AS curve represents an economy at full employment, where there is no spare capacity, hence resulting in only a change in price.
NoteIn the Keynesian model, expansionary fiscal policy can lead to inflation if the economy is already near full employment.
Contractionary Fiscal Policy
Contractionary Fiscal Policy
Fiscal policy aimed at reducing aggregate demand by decreasing government spending or increasing taxes.
Contractionary fiscal policy is used to close inflationary gaps by reducing aggregate demand.
- Observing the diagram above, the economy initially produces at $Y_{infl}$ which is above potential output, as $Y_{infl}>Y_p$
- The government can enact contractionary fiscal policies, such as:
- decrease government spending(↑G)
- increase income taxes (causing decrease in consumer spending)
- increase in corporate tax (causing decrease in business investments)
- This will cause a decrease the aggregate demand from $AD_1→AD_2$.
- As a result, the inflationary gap will be eliminated, and the economy will be producing at $Y_p$.
When the government uses contractionary fiscal policy (when current level is at LRAS):
- The aggregate demand decreases, shifting the curve to the left.
- In the short run, this leads to lower output and higher unemployment.
- However, in the long run, the economy returns to the full employment level of output, and the only effect is a lower price level.
For the Keynesian model, the effects of contractionary fiscal policy vary depending on the section of the AS curve the economy is in:
- If the aggregate demand were to fall along the vertical section (stage three) of the Keynesian AS curve, with a fall in price but no fall in output as seen from $AD_1$ to $AD_2$.
- Along stage two of the model, the shift in aggregate demand from $AD_3$ to $AD_4$ results in a reduction in price as well as output.
- However, if the AD were to fall along the (stage one) horizontal part of the AS, the fall in real output will be larger, while the decrease in prices would be much slower, due to their "stickiness".
- Remember, fiscal policy affects aggregate demand by affecting:
- Consumer Spending(C)
- Investment(I)
- Government Spending(G)
- Hence, if a government employs fiscal policy, one/all of these components will be changed.
Japan's Fiscal Policy Measures to Address Economic Gaps
Background:
Japan has faced prolonged economic challenges, including deflationary pressures and stagnant growth, particularly since the asset price bubble burst in the early 1990s. To combat these issues, the Japanese government has implemented various fiscal policy measures aimed at stimulating the economy and addressing deflationary gaps.
Expansionary Fiscal Policy to Address Deflationary Gaps:
In response to persistent deflation and economic stagnation, the Japanese government launched a series of stimulus packages. Notably, in 2013, under the economic strategy known as "Abenomics," the government introduced a substantial fiscal stimulus to spur growth.
Key components of the 2013 stimulus package included:
- Government Spending Increases: Approximately ¥10.3 trillion (about $116 billion) was allocated to infrastructure projects, disaster prevention, and technological innovation.
- Tax Incentives: The government provided tax breaks to encourage corporate investment and consumer spending.
These measures aimed to shift the aggregate demand curve to the right, thereby closing the deflationary gap and promoting economic recovery.
Contractionary Fiscal Policy to Address Potential Inflationary Gaps:
While Japan has primarily struggled with deflation, there have been instances where the government implemented contractionary fiscal policies to maintain fiscal discipline and prevent potential overheating.
For example:
- Consumption Tax Increase: In 2014, the government raised the consumption tax from 5% to 8% to increase revenue and address the national debt, which stood at over 200% of GDP.
- Further Tax Hike: A planned increase to 10% was initially scheduled for 2015 but was postponed due to concerns about its impact on consumer spending.
These measures were intended to shift the aggregate demand curve to the left, thereby preventing an inflationary gap and ensuring long-term fiscal sustainability.
Outcomes and Considerations:
The effectiveness of Japan's fiscal policies has been mixed. While expansionary measures provided short-term boosts to the economy, challenges such as an aging population and high public debt have limited long-term growth. The consumption tax increases aimed at fiscal consolidation have sometimes dampened consumer spending, complicating efforts to achieve sustained economic momentum.
Questions:
- Explain how Japan's 2013 fiscal stimulus functioned as an expansionary fiscal policy to address the deflationary gap.
- Discuss the potential advantages and disadvantages of implementing consumption tax increases as a contractionary fiscal policy measure in Japan.
- Evaluate the impact of government spending on infrastructure projects on Japan's aggregate demand and overall economic growth.
- Analyse the challenges Japan faces in balancing expansionary fiscal policies with the need for fiscal sustainability given its high public debt.
