In what macroeconomic circumstances will an expansionary fiscal policy lead to inflation?
An expansionary fiscal policy (reduction in taxes and/or increase in government spending) is likely to result in inflation if the economy is in the intermediate or the classical range of the aggregate supply curve.
Beginning economics texts portray the aggregate supply curve as having three portions. In the Keynesian portion, it is flat. This means that an increase in aggregate demand (AD) such as would be caused by expansionary fiscal policy, would lead to GDP growth without inflation. The next portion of the curve, the intermediate range, is upward sloping. An increase in AD in this range would lead to an increase in real GDP, but also to inflation. Finally, the classical range of the curve is vertical. An increase in AD there would lead only to inflation and to no GDP growth.
Thus, an expansionary fiscal policy will lead to inflation if the equilibrium at the present time (the intersection of the AD and AS curves) is in the intermediate or classical ranges of the AS curve.
Expansionary fiscal policy generally assumes the existence of a central bank recognized by the state in question. It also assumes that the state is relatively economically stable within the larger state fiscal ecosystem. Since states enact expansionary policy by purchasing their own bonds on the free market, the existence of a free market is also required. The general goal of these bond purchases is to suppress interest rates in order to make private loans less costly and catalyze investment activity. Expansionary fiscal policy therefore also requires relatively low barriers to investing.
If a state is in an economic depression for a reason such as famine or an embargo imposed by a different state, expansionary fiscal policy sometimes is not effective in restoring economic productivity. These macroeconomic conditions require more customized remedies.