Expansionary Fiscal Policy | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)
Expansionary fiscal policy can be used to reduce cyclical unemployment. Unemployment is when people are willing and able to work but cannot find a job. Cylical unemployment is caused by a lack of aggregate demand in the economy. Fiscal policy is the use of higher government spending or lower tax rates and would cause AD to shift to the right. AD = C + I + G + (X-M), so if G (government spending) increases, then AD would also increase as shown below.
AD RIGHT SHIFT DIAGRAM
The diagram also shows that output would increase from y1 to y2, which suggests an increase in real GDP (economic growth) and also lower unemployment. This happens because labour is a derived demand, so greater spending in the economy by the government would create demand for new jobs - for example if the spending was on the NHS/ roadworks, there would also be new jobs required that unemployed people could take up.
Another benefit of the use of fiscal policy is the multiplier effect, which is when an initial increase in AD leads to further increases in AD. For example, during COVID, the government increased spending with Eat Out to Help Out, where they spent money subsidising restaurants. This lowered the cost of going out to eat, which boosted consumer confidence, causing consumer spending to increase too. AD = C + I + G + X-M and C and G both increased, causing an increase in AD. Also if people are going out, they are likely to spend on other goods and services such as desserts or transport. Furthermore, the accelerator theory says that business investment is likely to increase when consumer confidence and consumer spending is high, because business confidence increases as a result of greater consumer confidence, so this can lead to even further increases in AD, causing further job creation and economic growth.
However, there are some consequences of fiscal policy which the government should be careful of. Firstly. if the multiplier effect is not controlled, it could lead to AD increasing too much, which would cause inflation. Inflation is bad because it leads to a cost of living crisis as people's wages stay low while prices rise. However, this is unlikely to happen if the economy was in a recession and there was enough spare capacity in the economy as shown by the output level being below yFE.
The biggest issue with expansionary fiscal policy is that it requires the government to run a budget deficit (government spending exceeds tax revenue). If this accumulates year after year, it would increase national debt. High levels of national debt is bad because it means the country will spend more each year on interest repayments, and this spending has an opportunity cost. Furthermore, future generations will have to run spending cuts or tax increases (austerity measures) which will mean that they may have worse living standards as they are receiving services (lower NHS spending) or getting less disposable income (higher income tax).