3.6.3—Expansionary and contractionary fiscal policy

Expansionary fiscal policy raises spending or cuts net taxes to support demand; contractionary policy does the reverse to reduce demand or debt pressure.

The effect depends on multiplier, interest rates, imports, confidence and spare capacity.

Match policy direction to the macro problem and state a trade-off.

During a recession, temporary infrastructure spending may raise output; near full capacity it may add inflation.

Policy direction does not guarantee the intended outcome.

Expansionary fiscal policy raises government spending or lowers taxes, shifting AD right to close a recessionary gap; contractionary policy lowers spending or raises taxes, shifting AD left to close an inflationary gap. In the monetarist/new-classical diagram, compare equilibrium with vertical LRAS at potential output. In the Keynesian diagram, the output-price mix depends on whether equilibrium lies on the flat, upward-sloping or vertical AS section. Label the initial gap, policy-induced AD shift and new equilibrium rather than assuming identical effects in both models.