In a recession, the government can spend more or tax less.
Expansionary fiscal policy, step by step
In a recession
Real GDP is below full employment; unemployment is high.
Spend more or tax less
Build roads and schools; cut income or sales taxes.
AD rises
G rises directly; lower taxes raise C and I.
More output, more jobs
Real GDP rises towards Yf; unemployment falls.
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In a boom, it can spend less or tax more to bring inflation down.
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The points to remember
- Write it like this: "Expansionary fiscal policy is when the government spends more or taxes less in order to increase AD, output and jobs."
- Contractionary fiscal policy spends less or taxes more to reduce AD and inflation.
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Economists disagree about how much output fiscal policy can add.
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Keynesian view
- In a deep recession AS is flat: more AD raises output, not prices.
- So fiscal policy is powerful when there is spare capacity.
Monetarist / new classical view
- In the long run output returns to LRAS: more AD only raises prices.
- So fiscal policy cannot keep output above its potential.
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Remember it as: Keynesian: output rises when there is spare capacity. Monetarist: in the long run, only prices rise.
Paper 2 asked this in May 2022, for 4 marks.
Using an AD/AS diagram, explain how a cut in government spending could reduce the rate of inflation.
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How the 4 marks are given
| Marks | What your answer needs |
|---|---|
| 3–4 | A correct diagram and a correct explanation |
| 1–2 | A correct diagram or a correct explanation, not both |
| 3 at most | A diagram with a wrong or missing label |