Expansionary Fiscal Policy: Risks and Examples

What Is an Expansionary Policy?

Expansionary policy is a form of macroeconomic policy that seeks to encourage economic growth by increasing aggregate demand. It can consist of either monetary policy or fiscal policy, or a combination of the two. It is part of the general policy prescription of Keynesian economics to be used during economic slowdowns and recessions in order to moderate the downside of economic cycles. Expansionary policy is also known as loose policy.

Understanding Expansionary Policy

The basic objective of expansionary policy is to boost aggregate demand to make up for shortfalls in private demand. It is based on the ideas of Keynesian economics, particularly the idea that the main cause of recessions is a deficiency in aggregate demand. Expansionary policy is intended to boost business investment and consumer spending by injecting money into the economy either through direct government deficit spending or increased lending to businesses and consumers.

From a fiscal policy perspective, the government enacts expansionary policies through budgeting tools that provide people with more money. Increasing spending and cutting taxes to produce budget deficits means that the government is putting more money into the economy than it is taking out. Expansionary fiscal policy includes tax cuts, transfer payments, rebates and increased government spending on projects such as infrastructure improvements.

For example, it can increase discretionary government spending, infusing the economy with more money through government contracts. Additionally, it can cut taxes and leave a greater amount of money in the hands of the people who then go on to spend and invest.

Types of Expansionary Policy

Expansionary Fiscal Policy

Expansionary fiscal policy are policies enacted by a government that often increases or decreases the money supply to make changes to the economy. In other words, governments can directly give money to individuals, businesses, or taxpayers. Alternatively, to slow the economy, it can take it away.

During expansionary periods, governments can increase spending on infrastructure projects, social programs, and other initiatives to boost demand and stimulate economic growth. They may also enact tax cuts to reduce taxes, which puts more money in consumers' pockets and stimulates spending. Governments can also increase transfer payments such as welfare, unemployment, or other benefits to increase household income.

Expansionary Monetary Policy

Expansionary monetary policy works by expanding the money supply faster than usual or lowering short-term interest rates. It is enacted by central banks and comes about through open market operations, reserve requirements, and setting interest rates. The U.S. Federal Reserve employs expansionary policies whenever it lowers the benchmark federal funds rate or discount rate, decreases required reserves for banks or buys Treasury bonds on the open market. Quantitative Easing, or QE, is another form of expansionary monetary policy.

For example, when the benchmark federal funds rate is lowered, the cost of borrowing from the central bank decreases, giving banks greater access to cash that can be lent in the market. When reserve requirements decline, it allows banks to lend a higher proportion of their capital to consumers and businesses. When the central bank purchases debt instruments, it injects capital directly into the economy.

How Expansionary Policy Is Implemented

Expansionary monetary policy is implemented by central banks to stimulate economic growth and combat economic slowdown. For the United States, the Federal Reserve is overseen by a collection of individuals. This Board of Governors that oversees the Federal Reserve System proposes, reviews, and votes on proposed regulation. These economic experts monitor macroeconomic conditions, implement changes, and review implications of those changes.

In other cases, measures are voted on my members of the government such as the House of Representative or Senate. These bills may include changes to tax policies, for example. This type of policy must be approved by all appropriate levels of government before implemented.

Once measures have passed by the Federal Reserve, the policies are communicated and implemented by the appropriate entities. For example, the IRS is then tasked with integrated tax breaks into Internal Revenue Codification. In another example, monetary rates are communicated through branches of lending, starting with the Federal Reserve branches and extending to other institutions.

The Risks of Expansionary Monetary Policy

Expansionary policy is a popular tool for managing low-growth periods in the business cycle, but it also comes with risks. These risks include macroeconomic, microeconomic, and political economy issues. Gauging when to engage in expansionary policy, how much to do, and when to stop requires sophisticated analysis and involves substantial uncertainties. Expanding too much can cause side effects such as high inflation or an overheated economy.

Risk of Outdated Analysis

There is a time lag between when a policy move is made and when it works its way through the economy. This makes up-to-the-minute analysis nearly impossible, even for the most seasoned economists. Prudent central bankers and legislators must know when to halt money supply growth or even reverse course and switch to a contractionary policy, which would involve taking the opposite steps of expansionary policy, such as raising interest rates.

Risk of Macroeconomic Distortions

Even under ideal conditions, expansionary fiscal and monetary policy risk creating microeconomic distortions through the economy. Simple economic models often portray the effects of expansionary policy as neutral to the structure of the economy as if the money injected into the economy were distributed uniformly and instantaneously across the economy.

In actual practice, monetary and fiscal policy both operate by distributing new money to specific individuals, businesses, and industries who then spend and circulate the new money to the rest of the economy. Rather than uniformly boosting aggregate demand, this means that expansionary policy always involves an effective transfer of purchasing power and wealth from the earlier recipients to the later recipients of the new money.

Risk of Corruption

In addition, like any government policy, an expansionary policy is potentially vulnerable to information and incentive problems. The distribution of the money injected by expansionary policy into the economy can obviously involve political considerations. Problems such as rent-seeking and principal-agent problems easily crop up whenever large sums of public money are up for grabs. And by definition, expansionary policy, whether fiscal or monetary, involves the distribution of large sums of public money.

Effects of Expansionary Policy

When the government enacts expansionary policy, there are far-reaching effects that impact economies in a number of ways.

When interest rates are lowered, the availability of credit is increased. This leads to an increase in consumer spending, driving economic growth. After all, the end goal of expansionary policy is to heat up the economy. The primary effect (or intended effect) of expansionary policy is to make people acquire and spend more money.

This effect also translates into business activity. Expansionary policy can also stimulate business investment by making it cheaper to borrow money for capital expenditures, leading to increased job creation and economic growth. For this reason, it's common for jobs to have more job openings or job creations during expansionary policy since capital is easier to come by.

Because consumers have more money and companies are hiring more, expansionary policy results in an increase in demand for goods and services. This often leads to more favorable manufacturing information, especially for firms that also invest in expansion using low cost of capital. This also creates a more balanced system of trades as companies undergoing expansionary policy may be cheaper to export.

All of this activity is meant to stimulate an economy. Unfortunately, in order to reduce unemployment, the primary negative effect of expansionary policy is inflation. An increase in the money supply can lead to inflation if it outpaces the growth of the economy. This means that prices, wages, and input costs increase; though people have more money (or better access to money), the prices they pay will be higher.

Examples of Expansionary Policy

A major example of expansionary policy is the response following the 2008 financial crisis when central banks around the world lowered interest rates to near-zero and conducted major stimulus spending programs. In the United States, this included the American Recovery and Reinvestment Act and multiple rounds of quantitative easing by the U.S. Federal Reserve. U.S. policy makers spent and lent trillions of dollars into the U.S. economy in order to support domestic aggregate demand and prop up the financial system.

In a more recent example, declining oil prices from 2014 through the second quarter of 2016 caused many economies to slow down. Canada was hit especially hard in the first half of 2016, with almost one-third of its entire economy based in the energy sector. This caused bank profits to decline, making Canadian banks vulnerable to failure.

To combat these low oil prices, Canada enacted an expansionary monetary policy by reducing interest rates within the country. The expansionary policy was targeted to boost economic growth domestically. However, the policy also meant a decrease in net interest margins for Canadian banks, squeezing bank profits.

Expansionary Policy During COVID-19

A more recent and extreme example of expansionary policy occurred during the COVID-19 pandemic. In response to temporary business closures and an immediately halted economy, the Federal government lowered interest rates from 1.5%-1.75% to 0%-0.25% around March 2020. In seemingly overnight, governments tried to make it as easy as possible for consumers and businesses to receive low-cost debt.

In an example of fiscal policy, the IRS issued three Economic Impact Payments during the pandemic. Taxpayers, assuming they did not exceed income thresholds, could receive three different payments: $1,200 in April 2020, $600 in December 2020, and $1,400 in March 2021. There were also additional Child Tax Credit opportunities.

One last example of expansionary policy during COVID-19 was the Federal Reserve's open market operations. The Treasury raised trillions of dollars by issuing Treasury bills, and the Treasury also held a historically high operating cash amount of $1.6 trillion on hand. It also increased its purchase of Treasury Securities and other debt instruments to inject capital into the market; it was not until 2022 that the Federal Reserve began easing these purchases.

The Bottom Line

Expansionary policy is a set of economic measures taken by a government or central bank to stimulate economic growth. These policies are intended to increase demand and aggregate spending. The goal of expansionary policy is to boost the economy during periods of slow growth or recession, though it may unintentionally increase the rate of annual inflation.