Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes.

Governments use fiscal policy such as government spending and levied taxes to stimulate economic change. Expansionary policy is characterized by increased government spending or lower taxes to boost productivity. Expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.

Expansionary fiscal policy includes tax cuts, transfer payments, rebates and increased government spending on projects such as infrastructure improvements. For example, it can increase discretionary government spending, infusing the economy with more money through government contracts.

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 of budget surpluses.

The Federal Reserve uses three main contractionary monetary tools: increasing interest rates, increasing banks’ reserve requirement, and selling government securities.

Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two.

Tools for an Expansionary Monetary Policy

1. Lower the short-term interest rates. The adjustments to short-term interest rates are the main monetary policy tool for a central bank.
2. Reduce the reserve requirements.
3. Expand open market operations (buy securities)

An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand.

An expansionary fiscal policy seeks to spur economic activity by putting more money into the hands of consumers and businesses. It’s one of the major ways governments respond to contractions in the business cycle and prevent economic recessions.