Which are more popular with citizens, contractionary or expansionary government actions, and why?

The two major examples of expansionary fiscal policy are tax cuts and increased government spending. Both of these policies are intended to increase aggregate demand while contributing to deficits or drawing down budget surpluses. Normally, they're employed during recessions to spur a recovery or amid fears of one to head it off.

Classical macroeconomics considers fiscal policy to be an effective strategy for use by the government to counterbalance the natural depression in spending and economic activity that takes place during a recession. As business conditions deteriorate, consumers and businesses cut back on spending and investments. This cutback causes business to deteriorate further and sets off a cycle from which it can be difficult to escape.

• Two examples of expansionary fiscal policy are tax cuts and increased government spending.
• Expansionary fiscal policy is used to prevent or end recessions, or to prevent high unemployment.
• The Economic Stimulus Act of 2008 allowed the government to put money directly into consumers' pockets in the hope of stimulating spending.
• A downside of expansionary fiscal policy tax cuts is that they must be reversed later.
• John Maynard Keynes identified fiscal policy as key to alleviating the negative economic consequences of slowing spending and economic activity.

During recessions, the purchasing behavior of individuals changes. They must make new decisions about the types of products to buy. Overall, their spending decreases. This reduction in spending and economic activity leads to less revenue for businesses. That, in turn, leads to greater unemployment and an even greater diminishment of spending and economic activity.

During the Great Depression, John Maynard Keynes was the first to identify this self-reinforcing negative cycle in his book, "General Theory of Employment, Interest, and Money." He identified fiscal policy as a way to smooth out and prevent these tendencies of the business cycle.

Faced with an economic slowdown, the government may attempt to bridge the reduction in demand by giving a windfall to citizens via a tax cut or an increase in government spending. This can create jobs and alleviate unemployment.

An example of tax cuts as expansionary fiscal policy is the Economic Stimulus Act of 2008, in which the government attempted to boost the economy by sending taxpayers $600 or $1,200 depending on their marital status and number of dependents. The total cost was $152 billion.

Tax cuts are favored by conservatives for effective expansionary fiscal policy because they have less faith in the government and more faith in markets.

Liberals tend to be more confident in the ability of the government to spend judiciously and are more inclined towards government spending, rather than tax cuts, as a means of expansionary fiscal policy.

An example of government spending as expansionary fiscal policy is the American Recovery and Reinvestment Act of 2009. This effort was made in the midst of the Great Recession and totaled $831 billion. Most of this spending targeted infrastructure, education, and extension of unemployment benefits.

A government can stimulate spending by creating jobs and lowering unemployment. Tax cuts can boost spending by quickly putting money into consumers' hands. All in all, expansionary fiscal policy can restore confidence in the government. It can help people and businesses feel that economic activity will pick up and alleviate their financial discomfort.

All the new spending spurred by expansionary fiscal policy can cause inflation to rise. Also, the tax cuts made to support spending must be reversed at a later time. Moreover, politicians can use expansionary fiscal policy for their political purposes, rather than for the good of the country.

The three types of fiscal policy are neutral, expansionary, and contractionary. A neutral policy is one where the government takes no steps to provide economic support because it feels the economy is healthy and stable. An expansionary fiscal policy involves increasing spending or cutting taxes to prevent or end a recession or depression. A contractionary fiscal policy involves cutting spending or raising taxes to slow down unsustainable economic growth.

Now that you know about the Federal Reserve’s policy tools, let’s see how the Fed uses the tools to achieve its dual mandate—maximum employment and price stability.

How Expansionary Monetary Policy Works

Suppose the economy weakens and employment falls short of the Fed’s maximum employment goal. Meanwhile, the inflation rate is showing signs that it will fall below the target. The Federal Open Market Committee (FOMC) might decide to use expansionary monetary policy to provide stimulus for the economy. That is, the FOMC could lower its target range for the federal funds rate (FFR).

When doing so, the Fed would decrease its administered interest rates—interest on reserve balances (IORB), overnight reverse repurchase agreement (ON RRP) offering, and discount—accordingly.

Expansionary Monetary Policy Graph

This animated graph of expansionary monetary policy shows how a cut in the federal funds rate target triggers a decrease in the Fed’s administered rates, which results in a lower federal funds rate.

These actions by the Fed would transmit to other market interest rates and broader financial conditions. Here is how expansionary monetary policy translates into the economy:

• Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services and businesses to invest in new equipment.
• The increase in consumption spending by consumers and investment spending by businesses increases the overall demand for goods and services in the economy.
• With increased production, businesses are likely to hire additional employees and spend more on other resources.
• As these increases in spending ripple through the economy, unemployment decreases, moving the economy toward maximum employment.

So, the Fed’s monetary policy tools can be effective for moving the economy back toward the maximum employment component of the dual mandate when the economy is weak.

How Contractionary Monetary Policy Works

Suppose that inflation has exceeded 2 percent for some time and the Fed recognizes that individuals are starting to expect high and rising inflation going forward. In this situation, the FOMC might decide to use contractionary monetary policy to bring actual and expected inflation back toward its target, to maintain price stability.

To do this, the FOMC could raise its target range for the federal funds rate (FFR) and increase the administered rates—interest on reserve balances (IORB) rate, overnight reverse repurchase agreement (ON RRP) offering rate, and discount rate—accordingly.

Contractionary Monetary Policy Graph

This animated graph of contractionary monetary policy shows how an increase in the federal funds rate target triggers an increase in the Fed’s administered rates, which results in a higher federal funds rate.

Here is how contractionary policy actions by the Fed would transmit to other market interest rates and broader financial conditions.

• Higher interest rates increase the cost of borrowing money, which discourages consumers from spending on some goods and services and reduces businesses’ investment in new equipment.
• The decrease in consumption spending by consumers and in investment spending by businesses decreases the overall demand for goods and services in the economy.
• With decreased production, businesses are less likely to hire additional employees and spend more on other resources.
• As these decreases in spending ripple through the economy, inflationary pressures would diminish and the inflation rate would fall back toward 2 percent.

Note that the goal of contractionary monetary policy is to decrease the rate of demand for goods and services, not to stop it. So, higher interest rates through contractionary policy can be used to dampen inflation and move the economy back to the price stability component of the dual mandate.