Governments raise taxes and use that revenue for expansionary or contractionary purposes. These fiscal policies are aimed at stimulating economic growth or slowing the rate of growth in the economy. Fiscal policies can either be contractionary or expansionary. In contractionary policy, the Government increases tax rate, while in expansion policy the Government reduces tax rate. When the Government applies expansion policy, crowding out occurs. In this policy, the Government spends more which reduces funds available in the economy due to increased interest rates. When the government raises the tax rate, it shifts the equilibrium for goods and services which is reflected in reduced consumer and production surplus.
Increased Government spending can create a multiplier effect. When the Government increases its spending through investment in infrastructure, it creates job opportunities. The people who will be employed will have more income to spend which will eventually increase aggregate demand. The amount injected in the economy may cause a bigger increase in the gross domestic product through a multiplier effect than the initial injection. However, some economists have argued that increased Government spending through high taxes can potentially lead to inefficient allocation of resources. In addition, Government spending reduces individual saving capability due to increased interest rates. This can potentially discourage investors from investing in productive ventures. Increased Government spending can also stimulate an inflationary effect in the economy. Typically, when the Government increases its spending, it increases capital supply in the economy which eventually devalues the currency.
On the other hand, Shaw and Liu noted that Government spending (expansionary policies) decreases net exports. When Government policies increase the rate of interest, it attracts foreign investors. This is because Government bonds in expansionary policy offer a higher rate of return. Foreign investors acquire that country’s currency in order to purchase Government bonds. The increased demand for that currency causes the local currency to appreciate. When the currency increases, export becomes more expensive while imports become less expensive.
Expansionary fiscal policy decreases private investment. When the Government is running a deficit budget, it issues bonds or monetizes the debts. In expansionary policy, the Government issue bonds at a higher interest rate. This can result to an increased interest rate in the overall economy since companies will be competing with the government for finance in the financial market. Thus, the issuance of bonds lowers aggregate demand for goods and services.