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Alexandre Marcondes Jeremy McCracken ECO210-017; Expansionary Fiscal Policy - Final Paper 17 November, 2010

A recession is defined by two consecutive quarters of negative growth in the economy and is observable on a Real Expenditure versus Real GDP graph via the recessionary gap, or the gap between the actual GDP, represented by the intersection of the aggregate demand curve and the forty-five degree angle line, and the potential GDP on the real GDP axis. To close this gap expansionary fiscal policy may be used. Expansionary fiscal policy is a policy that aims to strengthen the aggregate demand by method of either increasing government expenditures, decreasing taxes or both, causing the governments budget deficit to increase or surplus to decrease. By strengthening the aggregate demand, thereby moving the aggregate demand curve upwards on the Real Expenditure versus Real GDP graph, expansionary fiscal policy can close the gap between the potential and actual GDP. To strengthen the aggregate demand one or a combination of different four variables consumption [C], investments [I], government expenditures [G], or total imports subtracted from total exports [X - IM]used to calculate the aggregate demand must increase. Following an expansionary fiscal policy, there are three main ways by which the government can seek to strengthen the aggregate demand. The most commonly heard of the three methods by which government can influence the aggregate demand is tax cuts. Taxes, which are considered a leak from the economic cycle, can be cut by the government to increase the disposable income of households, thereby allowing individual portions of consumption, or C to increase. There are two issues with this method, however, one on the governments side and one on the side of the consumer. With tax cuts, the government must deal with a reduced income and an increased risk of deficit growth. The government must also depend on the consumer receiving the tax cuts to actually spend the extra money and to not save it. The human tendency in a recession is to save, which is understandable,

but if the marginal propensity to save is too high then the money, now in the hands of the consumer, will not be put back into the economy(,) thereby nullifying any positive effects the tax cuts might have had in strengthening the aggregate demand and instead having the negative effect of a decreased government income(,) making the next two methods less possible. The second option is for the government to increase transfer payments. Transfer payments occur when the government gives money to the consumers in order to increase disposable income in a more direct fashion than a tax cut. This method, however, has the same overall problem as tax cuts. Once the money has been transferred from the hands of the government to the hands of the consumer, it is imperative that the new funds be used for consumption and not for investment or else the transfer payment has little to no positive effect on the aggregate demand. If the consumer does not spend and instead invests the funds, then the government would have been better off increasing its own spending. The third and most direct method of affecting the aggregate demand curve that the government has is through the increase in its own outward spending, or government purchases. Government purchases of goods and services include everything from paper to airplanes and school teachers to police protection. This is the only method that guarantees that the governments money is in fact going towards the strengthening of the aggregate demand and not into the coffers of the unwilling and frightened consumers. The safest option when it comes to politics is tax cuts because it is both easier to implement and voters tend to prefer a tax cut over a direct increase in government spending via transfer payments and expenditure increases.