During times of high unemployment, investors, workers and government officials are all highly concerned with the options for producing economic growth. In tough economic times, economists often look to government policy to help address employment and output challenges. Understanding the basics of expansionary fiscal policy and how it effects economic output helps makes sense of this particular approach.
Basics of Fiscal Expansion
Fiscal policy, simply defined, is the agenda the government sets with regard to taxation and spending. Fiscal expansion occurs whenever the government decides to either spend more or lower taxes; fiscal contraction, by contrast, takes place when they government spends less or raises taxes. Fiscal expansionary policy is usually associated with government deficits, but a government doesn't have to necessarily run a deficit to engage in fiscal expansion -- it simply has to spend more or tax less than it did previously.
Effects on Demand and Output
In Keynesian economic theory, fiscal expansionary policy is generally associated with an increase in aggregate demand -- the total quantity of goods demanded by all consumers in the market -- and triggers growth in output. This has the effect of increasing economic production, especially in the short run. The reason for this is pretty simple: as the government spends more to build infrastructure, for example, it demands goods and services from the market. Producers respond to this new demand by increasing production.
Effects on Employment
When the government engages in fiscal expansion, it usually affects an increase in unemployment. This takes place for a couple reasons. Most immediately, it's because the producers respond to government demand by increasing production, which often requires more labor. This effect is also multiplied because, as producers hire new workers, the new workers are likely to begin spending more than they would if they remained unemployed. As the workers' demand for products and services also increases, producers respond by providing still more goods or services.
Long-Run Fiscal Contraction
While fiscal expansion tends to increase economic output and employment in the short-run, it is not likely to continue forever. Some of the reasons for this are economic, while others are political. When output and employment increase, governments usually begin to collect more tax revenue. This causes a kind of "automatic" contraction -- as tax revenue increases, government deficits decrease or surpluses grow. This kind of contraction is economic in nature and no policy changes are necessary to bring it about. In addition, governments eventually must pay down any debts that resulted from the fiscal expansion, which necessitates tax increases and spending cuts in the longer term. This type of fiscal contraction is political because governments must alter their taxation and spending policies to realize it. In the long-run, these impacts can potentially cancel out short-term increases in employment and output.