What are the Effects of Expansionary Fiscal Policy on Output and Employment?

Making sense of a complex macroeconomic theory.

Jan 15, 2016 at 12:09AM

Following the financial crisis, many Americans had their first experiences with macroeconomic theory, as the nightly news focused on the crisis and how the government was responding. One of the core tenets of the government's response was an expansionary fiscal policy. Let's dive into this theory to understand how it helps to boost output and improve employment.

What is expansionary fiscal policy?
Expansionary fiscal policy is, simply put, when a government starts spending more, or taxing less. In the U.S. today, expansionary fiscal policy is typically associated with an expanding deficit and national debt, but this policy doesn't necessarily equate to these two hot political topics. A government can have a budget surplus and still use this policy. The key is that it just spends more or taxes less, regardless of its budgetary surplus or deficit.

Governments pursue expansionary fiscal policies as a tool to stoke an economy into growth and to create jobs. The theory behind these decisions is based on the Keynesian Theory of economics, one of the more widely accepted and respected schools of thought today.

An expansionary fiscal policy is a powerful tool, but a country can't maintain it indefinitely. Eventually, its budget deficit will become too large, driving up its debt to an unsustainable level. Therefore, this policy is typically viewed as a short-term tool, not as a constant. That's why governments typically turn to expansionary policies during recessions and economic slowdowns rather than during times when the economy is doing well.

Impact on output and productivity?
According to Keynesian thinking, expansionary policy will increase output in the economy because of an increase in aggregate demand. If the government reduces taxes, the theory assumes that individuals and businesses will use their tax savings to buy more goods and services. That increase in buying will stoke the economy to produce more of the goods and services that consumes are demanding. More demand, therefore, brings about more output and productivity.

If the government increases its spending (as opposed to lowering taxes), then the increased demand from the government alone can be enough to prompt producers to increase their production to meet this new demand. The theory is that it is irrelevant where the demand comes from, so long as it is sufficiently large to stoke the increase in productivity.

I like to think of this logic as a "Field of Dreams" economic policy -- if you build aggregate demand, then increased productivity will come. In both the case of reduced taxation and increased government spending, the logic holds up, and history has shown the theory to work reasonably well.

Impact on employment?
After the increase in aggregate demand drives up production in the economy, the theory predicts that the labor market will be the next beneficiary. As producers increase their production and expand their operations to meet the new demand, they will, in theory, also hire new workers to support their growth.

In today's economy, one criticism of this theory comes from the increasingly powerful role technology is playing in productivity and efficiency. As the Internet, smart computers, and cheap sensors work congruently as part of the Internet of Things, many companies are finding ways to increase productivity without the need for major hiring initiatives. Many attribute this to so-called "jobless recoveries."

Take all theories with a grain of salt
Macroeconomics is extremely complex, and it is next to impossible to prove these theories as stone-cold facts. It's just very hard to pin down how this single policy impacts the highly complex calculus of international economics.

As an example of the fallibility of economic theory, we only have to look as far back as the Fed's near-zero interest-rate policy following the financial crisis. It was long accepted that quantitative easing and an easy money monetary policy would stoke inflation. However, since the Fed dropped interest rates to near-zero, inflation has remained very low in the U.S. In fact, deflation has become a more serious concern among many well-respected economists!

It's simply impossible to know if the relationship between interest rates and inflation is not as strong as once thought, if something has fundamentally changed in how inflation works, or if there is some other, stronger influence skewing the relationship we though we understood between interest rates and inflation.

The point is, be careful in accepting economic theory as fact. The world is a very complex place, and there are a near infinite number of factors that influence supply and demand. Expansionary fiscal policy may be a particularly strong influence on these markets, but it remains theory -- not fact

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