(a) Explain why expansionary fiscal policy designed to achieve economic growth or lower unemployment may lead to undesirable consequences. (10m)

Expansionary fiscal policy is a demand-side policy that entails increases in government spending and reduction in direct taxation such as personal income and corporate income tax to increase the Aggregate Demand (AD). AD comprises consumption, investment, government expenditure and net exports. Expansionary fiscal policy that leads to higher economic growth and lower unemployment could conflict with other macro goals such as price stability and favourable balance of trade (BOT).

Expansionary fiscal policy meant to increase economic growth and lower unemployment may lead to higher demand-pull inflation. For example, when there is an increase in government spending on building infrastructure to boost economic activity, there is an increase in AD which leads to an unplanned fall in firms’ inventories. Firms then increase their output and hire more factors of production. Through the multiplier effect, there is an increase in real NY and higher derived demand for available resources. As more resources are employed, the economy operates closer to full employment. While this is the ideal, more often than not, the government overshoots the extent of economic stimulus. When the economy is approaching full employment, resources become less available. Firms then have to utilise less suitable and less efficient factors of production, leading to a rise in unit cost of production. Thus, firms are willing and able to offer more output for sale only at higher prices, as shown by AS sloping upwards, and demand-pull inflation results as AD rises when the economy approaches full employment.

With reference to the diagram above, as G increases, AD increases from AD0 to AD1 for a corresponding increase in real NY from Y0 to Y1. However, if AD were to continue to rise to AD2 as the economy approaches its full employment level of output YF, then demand-pull inflation occurs as shown by a rise in GPL from P0 to P1.

Expansionary fiscal policy may also lead to worsening balance of trade (BOT). For example, when personal income taxes are lowered to increase disposable income, households will increase consumption and this leads to an increase in AD and real national income. As households’ income rises as an effect of the expansionary fiscal policy, their purchasing power increases and hence consumers would increase their demand for imported consumer goods. Thus, with increasing demand for imports from domestic buyers, import expenditure will increase. Assuming that export revenue does not rise as quickly, the balance of trade worsens. Further, owing to the effect of higher demand pull inflation as the economy nears full employment, this will reduce export price competitiveness and export price will rise, leading to a larger than proportionate fall in quantity demanded of exports, assuming PEDx > 1. Also, higher inflation will trigger a import substitution effect when domestic households and firms switch away from domestic goods and services to imports, leading to a rise in import expenditure. Accordingly, balance of trade will worsen and tilt into a deficit, assuming BOT = 0 initially.