Fixing a Broken Economy: Fiscal Policy & Stimulus

There are many things that can go wrong with a market economy. The effects of economic instability are often painful for individuals and families with limited resources. A breakdown of a country’s economy can lead to major social and political unrest and violence. Policy makers use fiscal policy and stimulus to avoid these effects.

What you need to learn

How do policy makers use fiscal policy to address economic instability?

The Great Moderation

The Great Recession

The American Recovery Act


fiscal policy to address economic gaps

expansionary fiscal policy

contractionary fiscal policy

deficit spending

austerity policies

spending effects for: welfare, unemployment, infrastructure, & tax cuts


recessionary gap

inflationary gap

effects of unemployment & inflation


crowding out & private vs. public spending

the multiplier effect

Fixing a Broken Economy

Problems in the economy, such as high unemployment, inflation, poverty, and economic inequality, often lead to political and social unrest. This happens through several interconnected pathways:

Unemployment and Job Insecurity: High unemployment rates mean that a large portion of the population is without a steady income, leading to financial struggles and a decrease in consumer spending, which further harms the economy. This situation can lead to social unrest as unemployed individuals and their families face hardships. Politically, people may lose confidence in the government’s ability to manage the economy, leading to protests, strikes, or the rise of opposition groups.

Inflation and Decreased Purchasing Power: Inflation, especially when wages do not keep up, reduces the purchasing power of citizens. This means people can afford less even though they might be working the same amount. Rising prices, particularly for essential goods like food and fuel, can lead to social discontent as everyday life becomes more expensive and difficult. The history of revolutions and protests, such as the French Revolution or more recently the Arab Spring, often points to inflation and food prices as a catalyst for social upheaval.

Poverty and Economic Hardship: Persistent poverty and economic hardship can lead to a sense of hopelessness and frustration among the affected population. This can manifest in increased crime rates, social tension, and even violent protests. People living in poverty often feel marginalized and may lose trust in political institutions, believing that the government does not represent their interests or is incapable of improving their situation.

Economic Inequality: Significant disparities in wealth and income can create a divide in society. The wealthy may become isolated from the rest of society, while those less fortunate may feel increasingly disenfranchised. This can lead to social unrest, as people demand more equitable distribution of wealth and resources. Politically, it can lead to the rise of populist leaders who exploit economic frustrations and promise radical changes.

Frustration with Policy Responses: When governments fail to effectively address economic problems, public frustration can grow. Austerity measures, for example, often lead to public sector job cuts, reduced social benefits, and higher taxes, which can further aggravate the economic hardships faced by citizens. This can lead to protests and a loss of faith in political leaders and institutions.

Spillover into Other Areas of Society: Economic problems can exacerbate other social issues like racial, ethnic, and gender inequalities, leading to wider social unrest. Economic downturns can intensify competition for jobs and resources, sometimes leading to xenophobia or ethnic conflict.

In essence, economic problems can create a cycle where financial hardships lead to social and political unrest, which can then further harm the economy, creating a feedback loop of instability. This relationship underscores the importance of stable and inclusive economic policies in maintaining social and political harmony.

Recessionary and inflationary gaps

Recessionary and inflationary gaps are concepts used in economics to describe situations where an economy is not operating at its full potential. A recessionary gap indicates underutilization of resources and is associated with unemployment, while an inflationary gap indicates overutilization and is associated with inflation. Both situations are undesirable, and economic policies (monetary and fiscal) are often aimed at bringing the economy back to its full-employment level, where the output equals the potential output, minimizing these gaps.

Recessionary Gap:

Definition: A recessionary gap occurs when an economy’s real Gross Domestic Product (GDP) is lower than its potential GDP. In other words, the economy is producing less than it could if it were operating at full employment.

Causes: This gap can be caused by a decrease in aggregate demand, which might be due to lower consumer spending, reduced business investment, government spending cuts, or a decrease in net exports. Such a drop in demand leads to a surplus of resources, including labor, resulting in higher unemployment.

Example: The Great Recession that began in 2008 is a prime example. The collapse of housing market prices and the ensuing financial crisis led to a significant drop in consumer confidence and spending, resulting in businesses cutting back on production and laying off workers, creating a recessionary gap.

Inflationary Gap:

Definition: An inflationary gap exists when an economy’s real GDP exceeds its potential GDP. This happens when aggregate demand exceeds the economy’s ability to produce goods and services, leading to upward pressure on prices, or inflation.

Causes: This gap can be caused by factors such as excessive consumer spending, high levels of government expenditure, booming exports, or rapid growth in business investments that push the demand beyond the economy’s productive capacity.

Example: The economic boom of the 1960s in the United States, fueled by increased government spending on social programs and the Vietnam War, led to an inflationary gap. The economy was operating above its potential, leading to increased inflation.

Expansionary and contractionary fiscal policies

Expansionary and contractionary fiscal policies are tools used by policymakers to manage economic cycles and address economic gaps, such as recessionary and inflationary gaps. These policies involve adjustments in government spending and taxation to influence the level of aggregate demand in the economy. Let’s explore how each policy can be used:

Expansionary Fiscal Policy:

Purpose: Expansionary fiscal policy is used to close a recessionary gap. The goal is to increase aggregate demand, which can help boost production, increase GDP, and reduce unemployment.


  • Increased Government Spending: This could involve government investment in infrastructure projects, education, or healthcare, which not only creates jobs but also can improve long-term economic prospects.
  • Tax Cuts: Reducing taxes puts more money in the hands of consumers and businesses. Consumers can spend more, while businesses have more capital for investment.

Example: During the 2008 financial crisis, many governments implemented expansionary fiscal policies, including large-scale stimulus packages, to spur economic activity and counteract the effects of the recession.

Contractionary Fiscal Policy:

Purpose: Contractionary fiscal policy is aimed at cooling down an overheated economy, typically characterized by an inflationary gap. The goal is to decrease aggregate demand, which can help stabilize prices and prevent the economy from overheating.


  • Decreased Government Spending: Reducing government expenditures can help pull back on aggregate demand, thus easing inflationary pressures.
  • Tax Increases: Raising taxes reduces the disposable income of consumers and the profits of businesses, leading to decreased spending and investment.
  • Example: In the late 1960s and early 1970s, several governments used contractionary fiscal policies to combat the high inflation resulting from the economic booms and expansive fiscal policies of the 1960s.

Balancing Act:
Implementing these policies requires a careful balancing act. Expansionary fiscal policy, while stimulating economic growth, can lead to higher government debt and potentially higher inflation in the long run. Contractionary policy, on the other hand, can slow down economic growth and increase unemployment. Policymakers must therefore carefully consider the current economic situation and potential long-term effects when deciding on fiscal policies.

Additionally, the timing and magnitude of these policies are critical. Implementing them too early or too late can either exacerbate existing problems or create new ones. Moreover, the effectiveness of fiscal policies can be influenced by other factors, such as consumer confidence, global economic conditions, and the reactions of businesses and financial markets.

Keynesian fiscal policy

Keynesian fiscal policy is based on the ideas of British economist John Maynard Keynes, particularly as outlined in his influential work during the Great Depression, “The General Theory of Employment, Interest, and Money” (1936). Keynes challenged the classical economic thought of his time, which suggested that markets were always clear and that economies would naturally return to a state of full employment. Instead, Keynes proposed that during times of economic downturns, aggregate demand is often insufficient to drive full employment. This led to his advocacy for government intervention in the economy through fiscal policy. Let’s delve into the core principles and applications of Keynesian fiscal policy:

  1. Role of Government Intervention: Keynes argued that in times of economic downturns, when private sector demand is insufficient, the government should step in to fill the gap. The government can increase aggregate demand, thus stimulating economic activity and reducing unemployment.
  2. Expansionary Fiscal Policy: In a recession or depression, Keynesian economists advocate for expansionary fiscal policy. This includes increasing government spending and/or decreasing taxes. The idea is that government spending directly increases aggregate demand, while tax cuts leave consumers with more disposable income and encourage spending.
  3. Multiplier Effect: A key concept in Keynesian economics is the multiplier effect. This refers to the idea that an increase in spending (for example, through government investment in infrastructure) leads to increased incomes for those involved in the projects, who then spend their increased income, thus further increasing aggregate demand. The initial spending thus has a multiplied effect on the economy.
  4. Contractionary Fiscal Policy in Boom Times: Keynesian theory also suggests that in times of economic boom, when the economy is at risk of overheating and causing inflation, the government should use contractionary fiscal policy. This means decreasing government spending and/or increasing taxes to reduce aggregate demand, thus helping to control inflation.
  5. Counter-Cyclical Fiscal Policies: Overall, Keynes advocated for what are known as counter-cyclical fiscal policies. This means that the government should act in opposition to the business cycle: spend and cut taxes during recessions (expansionary policy) and save (or pay off debt) and increase taxes during booms (contractionary policy). The goal is to stabilize the economy – smoothing out the peaks and troughs of economic cycles.
  6. Budget Deficits and Surpluses: Keynesian policy accepts the notion of running budget deficits in tough economic times to finance increased government spending and stimulate the economy. Conversely, during good economic times, governments should aim to run surpluses and pay down debt.
  7. Policy Time Lags: Keynesians acknowledge that fiscal policy has time lags. It takes time to recognize an economic problem, implement policy, and for the policy to have an effect. Therefore, timing and responsiveness are crucial in the effectiveness of fiscal policy.

Keynesian fiscal policy had a significant influence on economic policies, especially in the mid-20th century, leading to the adoption of more active roles for governments in managing economies. Although its popularity has fluctuated and it has faced criticism (notably from monetarist and supply-side economists), many of its principles still underpin fiscal policy decisions today.