Pros and Cons of Using Expansionary and Contractionary Fiscal Policy

Expansionary and contractionary fiscal policies raise and lower money supply, respectively, into the economy. In this Buzzle article, you will come across the pros and cons of using expansionary and contractionary fiscal policy.

Please Note:

Do not get confused between fiscal policy and monetary policy. They are two different terms. The former is related to taxes and spending, while the latter deals with the supply of money and its effects on the rising and falling interest rates.

A fiscal policy defines the relationship between taxation and expenditure. It uses a variety of tools for this purpose, in turn, having a profound effect on factors like unemployment, inflation, aggregate demand, and investments. It is mainly divided into 2 types: expansionary and contractionary. However, a third stance called 'neutral' has been identified as well, which is normally adopted when the economy is in an equilibrium state. The paragraphs below will explain the advantages and disadvantages of both the main policies in detail.

Expansionary Fiscal Policy

• It is a policy that helps increase money supply in the economy.
• It is generally adopted during low economic growth phases.
• It also causes an increase in the demand for foreign bonds.
• Decision to employ this policy can come from the central bank or the government.
• It leads to increased exports and helps maintain balance of trade.
• It increases the expenditure of the government.

Pros

Cons

▲ It increases productivity, since it aims at increasing money supply. There is an increased demand for goods and services, and companies gear up for rising production in terms of quality and quantity.

▲ It increases the expenditure of the government, thereby leading to reduced taxation. A reduction in taxes would lead to an increase in the deficit of the government's budget. This would lead to high borrowing and rising government debt.

▲ It helps fuel the economic growth of the nation, especially during a recession. Hence, it is typically adopted during low-growth phases. It reduces restrictions on loan applications and interest rates, and leads to an increased outpouring of capital into the economy.

▲ There is a lack of price stability on various products. The increase in money supply causes it to lose its importance as regards to the related products, and higher costs are set for limited goods.

▲ Due to an increase in revenue and profits, there is a rising demand for labor. Since borrowing is made easier, companies find it profitable to increase operations and hire new employees. Thus, it leads to reduced unemployment.

▲ If the government isn't very careful regarding its expenditure and if there is excess money supply, this policy could lead to inflation. Increased inflation leads to unnecessary problems in the economy.

Contractionary Fiscal Policy

• It is a policy that helps decrease money supply in the economy.
• It is generally adopted during high economic growth phases.
• Decision to implement it can come from the nation's finance ministry or the central bank.
• It leads to increased imports.
• It decreases expenditure of the government.
• It increases the rates of interest and the reserve requirements.

Pros

Cons

▲ Since it involves less government expenditure, there is an increase in taxation, which leads to reduced spending. This can be used to pay off excess debts or accumulate surplus.

▲ Since there is reduced money supply, there is a slowing down of production. Companies have restriction on borrowing, and this leads to reduced operations and manufacturing. Once production slows down, it takes a long time to gear up again.

▲ It stabilizes prices and increases consumer confidence. Reduced price fluctuation leads to non-erratic expenditure.

▲ It reduces economic growth since there is reduced supply of money. Reduced prices, less demand, etc., leads to stunted economic growth.

▲ It slows down the inflation. This is also achieved through reduced government spending. Interest rates can be raised, and this leads to reduced demand and prices to match the low money supply.

▲ It leads to increased unemployment. In order to slow down production and raise interest rates, companies do not hire new employees. The demand for labor is reduced, prices decline, people have less money, therefore, consequently, employment sees a reduction.

Things To Remember

• During extensive recession, expansionary fiscal policy may not cause inflation.
• Legislators and bankers must be able to judge when to reverse the policy and halt money supply in the light of circumstances and market scenarios.
• When the economy needs to be slowed down immediately, central banks can reduce lending amounts and increase reserve requirements.
• Lower interest rates lead to lower exchange rates, which causes trade equilibrium.
• Increased economic activities through investments on assets may lead to crowding due to reduced spending by the private sector.

Both fiscal policies described above are crucial in the field of economics. As enlisted above, both have their benefits and losses. It is up to the government or the bank to use the right methodology considering the current economic scenario. The factors influencing the money supply must be discussed in detail, analyzed at length, and only then a decision must be taken regarding which policy is to be adopted at the time. A small error can cause an enormous loss of capital, hence the pros and cons must be understood in-depth.