Fiscal policy means the use of budgets and related legislative measures to try to influence the direction of the economy. Expansionary fiscal policy refers to reducing taxes and increasing government spending to stimulate the economy. The multiplier effect of expansionary policy spurs economic growth, which leads to increased investment, consumption and employment.
Expansionary fiscal policy results in a multiplier effect. As Jane G. Gravelle of the U.S. Congressional Research Service explains, when the government spends an extra dollar, someone receives it. He may save part of it and spend part of it, depending on his disposable income. This creates a multiplier effect in the economy because the next person receiving the spending would also spend part or all of it, and so on. Tax reductions have a similar multiplier effect. Lower taxes mean more disposable income, which leads to additional spending and economic growth.
Expansionary fiscal policy means increased government investment. This includes stimulus spending, relaxation of unemployment insurance qualification rules and increased transfers to other levels of government. For example, after the 2008 financial crisis, governments worldwide implemented massive stimulus programs to stabilize their respective economies. The concept behind stimulus spending is that a government steps in to fill the investment void left by downsized and cash-constrained businesses. Private investment gradually picks up as government purchases drive up demand for both labor and raw materials.
Increased public and private sector investments lead to more jobs. For example, the funding of a highway construction project means jobs for construction workers and support staff in potentially dozens of small communities. These projects require raw materials and finished goods from suppliers who increase production shifts and hire additional staff to satisfy demand. Governments often implement job-retraining programs as part of stimulus programs, which allow unemployed workers to learn the skills that are currently in demand or are likely to be in demand in the future.
People spend when they have disposable income. Groceries and basic household items come first, followed by discretionary items, such as new clothes and furniture. This results in increased business consumption because factories must buy raw materials to produce these goods. This increased consumption creates a virtuous circle that generates more investment, consumption and employment in the economy.
Increased business activity and consumer demand could lead to inflation, which might lead to increasing interest rates. Expansionary policy in a period of falling tax revenue could lead to deficit spending. Deficit spending may crowd out private sector investment because investors prefer to invest in low-risk government bonds rather than in higher-risk corporate bonds. There is also the lag effect, which refers to the time it takes to implement a fiscal policy measure.