Explain the difference between expansionary and contractionary fiscal policy.
The difference between expansionary and contractionary fiscal policy is that one is meant to make the economy expand and the other is meant to make it slow down. Another way to think of it is that one of them is meant to ensure that people have more money to spend while the other is meant to make them have less.
When the economy is expanding too rapidly, we want people to have less money to spend. There are two ways that government can try to do this. First, it can raise taxes. Second, it can reduce government spending. In both cases, people have less money and aggregate demand falls. When aggregate demand falls, so does the price level.
When the economy is in a recession, we want people to have more money to spend. Therefore, the government lowers taxes and/or increases spending. In both cases, these policies put more money in people’s pockets. This makes aggregate demand go up. Hopefully, that makes GDP rise as well.
So, the difference is that expansionary policy increases economic activity by giving people more money to spend while contractionary policy decreases economic activity by making sure they have less money.