Economics – Links between macroeconomic problems and their interrelatedness | e-Consult

Expansionary fiscal policy, such as increased government spending or tax cuts, aims to boost aggregate demand. According to the traditional Phillips curve, this will likely lead to a decrease in unemployment and a corresponding increase in inflation in the short run.

Explanation: Increased government spending or tax cuts directly increase aggregate demand (AD). This higher AD puts upward pressure on prices, leading to inflation. Simultaneously, the increased demand for labour associated with the economic stimulus will reduce unemployment. The traditional Phillips curve predicts this trade-off – lower unemployment at the cost of higher inflation.

Potential Drawbacks:

• Inflationary Risks: The primary drawback is the risk of accelerating inflation. If the expansionary policy is too large or sustained, it could lead to a significant rise in inflation, potentially eroding purchasing power and distorting economic decision-making.
• Limited Effectiveness in the Long Run: While the policy might initially reduce unemployment, the long-run effect is limited. The economy will eventually return to its natural rate of unemployment, regardless of the inflation rate. This means that the policy might only provide a temporary boost to employment.
• Potential for a Wage-Price Spiral: If inflation rises significantly, workers may demand higher wages to maintain their living standards. Firms may then pass these higher wage costs onto consumers in the form of higher prices, creating a wage-price spiral that further fuels inflation.
• Crowding Out: If the expansionary fiscal policy involves increased government borrowing, it could lead to crowding out – where government borrowing increases interest rates, reducing private investment and offsetting some of the positive effects on aggregate demand.