Fiscal Policy: The Best Case Scenario

The best-case scenario for expansionary fiscal policy is when there are lots of underemployed resources in the economy, and the government is good at identifying and targeting these resources. In this video, we'll show how to analyze the effects of expansionary fiscal policy using the aggregate supply and demand model.

We'll start with an economy that's growing at 3%, or at point "A" on the graph. Let's say, now, consumers become fearful about the future, and so they cut back on their consumption. Assuming no other changes in the economy, a drop in consumption shifts the aggregate demand curve to the left and down. The economy is now operating below its optimal level. It's no longer growing at 3%.

In fact, as shown, real growth is negative, and a recession is underway. Even though the economy's growth potential is still 3% a year, when consumers suddenly stop spending, the economy takes time to adjust -- in part because wages and prices are sticky. So, the reduction in consumption creates a temporary reduction in the real growth rate as well. Of course, in the longer run, the fear will subside, and consumption will return to previous levels. That will mean the economy will readjust back to its potential. That's great, but even though everything may be fine in the long run -- still, we don't only live in the long run.

As economist John Maynard Keynes once famously said, "In the long run, we're all dead." So, rather than waiting around for the long run, the government might try to step in to try to mitigate this slow, and sometimes painful, adjustment process. By increasing spending, the federal government can try to counteract falling aggregate demand. Or, the government could decrease taxes, hoping to increase private consumption.

For now, let's assume the government decides to increase its spending to combat this economic slump. An increase in government spending, if done with sufficient promptness, will increase the velocity of money, causing the aggregate demand, or "AD" curve, to shift to the right. And in one scenario, government spending doesn't have to be as large as the fall in "C," or consumption, to counteract the recession, and that's because of the multiplier effect.

Now we've demonstrated a situation where expansionary fiscal policy perfectly offsets the initial fall in consumption. But, as always, shifting lines on a graph is much easier than shifting around real resources in a multi-trillion dollar economy. Fiscal policy has many implementation challenges, and we'll turn to these next.