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Contractionary Fiscal Policy And Expansionary Fiscal Policy Economics Essay

Paper Type: Free Essay Subject: Economics
Wordcount: 4293 words Published: 1st Jan 2015

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In this assignment, we will discuss about the action or type of fiscal policy adopted by China government to prevent their economic affected by the Global Financial Crisis as most of the country economic in the world was harmed. An expansionary or proactive fiscal policy was adopted by China government to burst their economic by increasing domestic demand in country. An economic stimulus package worth around 4 trillion RMB was planned by China government which involved investment on various industries in country. The final target of this stimulus package is to create a stability economic growth by boost the domestic demand in China. Basically the ideal of stimulus package can be described as below table:

Table 1: 4 Focuses of China Stimulus Package on 2009.

4 Focuses

An increase in government spending which worth 4 trillion RMB. Government will directly take part of around 1.18 trillion RMB while the rest will be covered by local government.

Ten key industries were defined as the main focuses area to boost the economic growth.

Achieve country development by technological innovation and advance scientific knowledge.

Ensure social security was protected and increase the social development in rural area.

Source: China Fiscal Policy during Post-Crisis Era, JIA Kang & LIU WEI (2011).

The purpose of the China stimulus package is to prevent the economics of their country against the global financial crisis during year 2007-2008. The increase in government spending is always the most effective way to prevent economic slowdown and boost the economic activities in a country. The direct spending into the market from government will create more demand in the domestic market against the reduction in demand from foreign market due to the global financial crisis.

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Below chart will show us about the Investment portfolio worth total 4trillion RMB to be launch during year 2009-2010. Basically it can be divided into 7 major components which is post-earthquake reconstruction (1 trillion RMB), Civilian project (400billion RMB), Rural civilian project (370billion RMB), infrastructure (1.5trillion RMB), Social Welfare (150billion RMB), Sustainable environment (210 billion RMB), lastly will be Technology advances and industry restructuring (370 billion RMB). From here we can see that, the government stimulus package is more focus on the spending in infrastructures and public facilities to boost their economy. It is good for us to see that China’s government trying to spend more on public infrastructures and facilities in order to attract more investment from private sector, either from domestic market or foreign market. A greater spending on public infrastructure and facilities will provide a better business environment and it will create the opportunity to attract more investment from private sector. It can be seen as the capital injection by China government into the market will create a multiplier effect when attract investment fund from private sector or encourage more spending from consumer market.

Table 2: Investment portfolio of China’s Stimulus Package

A big spending from China’s government will be one of the ways for government to inject capital or money into their country economic. It’s always seem as an effective tool to for the government to directly get involved in their country economic activities rather than just rely on the “Invisible Hand” theory to wait their economic have a self readjustment process and recover back to normal situation.

Here, we would like to have a further discussion about what are the actual action take by China Government and what are the result they achieved under their expansionary fiscal policy by stimulus package for year 2009-2010.

Increase of Government spending on public sector

The total spending on public sector will cover certain areas like railways, road, airport, power grid, disaster reconstruction, social welfare, water and electricity, healthcare, education and etc. However, the major part of the government spending on public sector was the development of country’s infrastructure; it covered around 40% out of the total value of the stimulus package. The increase in government spending on infrastructure project will create more public benefit, investment or business opportunities in private sector, and it also implies that the more investment from private sector will come together with the increase in spending by government.

Increase Consumption

In recent years, the low labor cost and materials cost in China providing them the opportunity to sell their product or export the product on cheaper price to other country. It’s also the main reason why the GDP of China maintaining in over 8% for few years recently. However, the recent global financial crisis was harmed most of the countries in the world and it also affected the amount of product export to other countries seem the economic slowdown will reduce the demand of other countries to China products. One of the purposes of China stimulus package for year 2009-2010 is to replace the reduction in international demand by increasing their domestic demand. It can be perform in the way like increase the income of citizen (e.g. tax reduction or tax rebate), and provide a better quality of public service to attract consumption (e.g. convenience healthcare systems, improve quality of education, and etc.).

Changed in Labor market

The infrastructure development projects are more focus on rural area and the transport network between rural and city. The development of rural area in China’s respectively lack behind if compare with the development in city areas. We can definitely see it from the pricing from 2 places, for example a condominium in Shang Hai’s might cost you a million RMB or even much more higher than that. However, a bungalow unit in rural areas might only cost you just a few hundred thousand. The lack behind of development of rural areas causes the surplus of labor and it’s also the reason rural citizen are starting to move to city in order for them the get a job opportunity. A huge amount of migration population from rural areas to city areas was cause the population in city become very crowd and it have create a lot of social security issues. Based on the stimulus package 2009-2010 for China’s, the government will use a big spending to develop the infrastructures and public facilities in rural, in order to attract more investor to invest in rural areas and create more job opportunity at there. This action can also solve the labor surplus problem in rural areas of China’s and increase income of citizen in rural areas to make rebalance the income inequality between citizen in city and rural areas.

Protect Export

The infrastructure development in rural areas can attract the investor from both domestic market and foreign market to make investment on that area. A setting up cost of production line in rural areas will basically more cheaply than the cost to setting up a production line in city areas. One of the disadvantages of setting up of production line in rural areas will be the transportation problems, but it seem can be solve by the railway and highway network that is going to build up under the stimulus package of China’s. A relative low of cost of production in rural areas will provide the pricing advantages of China’s product compare with the product from other countries. It can attract more buyers of China’s products and increase the export to other countries while China’s can also earn foreign currency from their trade surplus in international market. The huge amount of export from China’s to other countries will seem as an inflow of foreign currency or money into China’s market, and it’s the main sources of income for China’s to generating their economic activities and increase the income level of their citizen. In the same time, an sustainable amount of export to other countries implies that the production capacity surplus can be avoided to make sure the country economic continuing to develop.

Besides from the RMB 4 trillion stimulus packages, China government also announced tax waivers and reductions which benefit specific industries, such as reduced sales taxes for small engine car and incentive for rural households to buy electrical appliances aims towards global economic recovery.

Impact of Stimulus Package as Expansionary Fiscal Policy

Effect of from macroeconomic management by using fiscal policy as a tool has been widely debated, because there are many empirical studies find different and sometimes conflicting results. Keynesian argues that the fiscal spending multiplier is greater than one, while the neoclassical say it is less than one. Besides that, the multiplier also can turn negative under certain conditions. According to Capet (2004), the fiscal spending multiplier for the short-term is estimate from 0.6 to 1.3. Besides that, Al-Eyd et al (2004) find that the spending multiplier is usually larger than the tax multiplier.

China’s stimulus package creates additional demand on investment goods, growth in investment related production sector, current production and trade capacities which include capital, land, and labor. In fact, as production of more industrialized sectors start to grow, china’s household’s income and consumption also will increase, it will provide the market opportunities for those agricultural and service sectors that mainly produce for the local market.

In details, to increase supply for capital good production sector, demand for labor, capital, and intermediates will be increase to produce more output. Increase demand of labor will creates jobs for unemployed labor and raises the wage rate, while increase demand of capital will raises the return to capital that lead private sector investment more profitable in future. In the other hand, Market of intermediate goods will be create when increase in demand, therefore, demand will be meet when increase supply of the goods. Due to production growth, private sectors including households and firm’s income will be increase and so do their savings.

As government invests public good in the stimulus package, it also brings some positive effect to the private sector productivity. For an example, transportation and transaction costs for a firm can be reduce significantly due to improve of roads quality and better infrastructural. Furthermore, stimulus package also include the investment in technological change and innovation, with such action, China’s competitiveness in the world can be improve as expected increase rapidly in productivity grow.

Due to the China’s stimulus package just start in late of year 2008, it takes time to implement and the result cannot be show immediately. To analyze the impact of this stimulus package, a dynamic computable general equilibrium model (DCGE) can be use to study the economic impacts of the recent global recession and China’s stimulus package. Basically DCGE model is a multisectoral general equilibrium model which captures economic activities on both demand and supply sides. The DCGE model unable to fully assess the whole process of economic response to a stimulus package, because excludes the financial movement of the economy or monetary policy effect.

Impact on Gross Domestic Product

Without taking stimulus package by China government into account, the analyzed from the research by Xinshen Diao, Yumei Zhang, Kevin Z. Chen (2010) show large negative growth effect for the China due to recent global recession.

Figure 1: Annual growth rate of total and sectoral GDP in the base run (%), 2008-15

This research ignore the decline in the China economy in 4th quarter of 2008, it show a higher growth rate compare to data reported by China’s National Bureau of Statistics.

Table 3: Growth Rate of Selected Economic Indicator

Sources: GDP data from China Statistical Yearbook (NBS 2009a) and website of National Bureau of Statistics of China Trade (China Custom Statistics 2009); foreign direct investment (FDI) data from website of the Ministry of Commerce of China (Ministry of Commerce 2009).

Impact on Exports and Imports

Author state that the growth of overall economy led by growth in the industrial sector which includes construction sector and export oriented manufacturing sector. Trade sector contribute to the primary factor to the declining industrial growth. Most of the export oriented manufacturing sectors in China are also import-intensive. Thus, when their production falls, demand for imported material or intermediates also will falls, and the falling rate can be greater than falling rate of export due to side effect.

Figure 2: Growth rate of total exports and imports (%), 2008-15

Impact on Sectoral Gross Domestic Product

In figure 3 bellow, the growth rate of total GDP in the stimulus run on year 2009 is still lower than in year 2008 due to global crisis, but it is much higher than in base run which 8.9% compare to 2.9% in the same year. Besides that, the industrial, services and agricultural sector also benefits from the stimulus package.

Figure 3: Annual growth rate of total and sectoral GDP in the base run (%), 2008-15

Figure 3.2: Annual growth rate of total and sectoral GDP in the stimulus run (%), 2008-15

In general, utilize of production capacity explained the growth in industrial sector while another two sectors which is service and agricultural sector raise driven by demand. From the stimulus package, it is obvious the government target domestic investment and demand for domestic factors and inputs because most measures applied in this few areas. As a result, the main engine for this stimulating growth by the stimulus package will be effect of domestic demand.

Figure 4: Growth in domestic demand and produced products, base and stimulus runs, 2008-15

From the figure above, domestic production sector other than mining and manufacturing falls sharply in year 2009 without stimulus run, while during the same period with stimulus run, growth rate raise in all the domestic production sectors. Besides that, in figure 5, it shows the stimulus package also benefits to trade in either domestic production or consumption. Although there is an improvement, but it will not back to the peak in recent years unless government reduce dependency on external markets and focus on domestic markets in growth.

Figure 5: Share of exports in total production & Share of imports in total demand, base and stimulus runs (%) 2008-15

From the DCGE research model, when China experience global recession and without a government stimulus package, demand for labour will be decline or stop growing. If government implement the stimulus package, result estimate to be move towards another way which increase in demand of labour. The reason behind an increase demand of labour is due to job opportunity created in the industrial and service sector. The results contribute to one of the important design of this stimulus which is to lower the unemployment pressure in China.

Figure 6: Growth in low-skilled labour demand under base and stimulus run (%) 2008-15

According to Xinshen Diao, Yumei Zhang, Kevin Z. Chen (2010)’s research, the accumulative gains of stimulus package lead China’s GDP to increase about 76 trillion RMB over the next seven years and it will be three times of China’s 2007 GDP. On the other hand, China’s total exports also expected to gains about US$ 5.6 trillion from the period. The figure may still be an underestimated figure because expected long-run impact of public investment on growth and other factors.

Figure 7: Overall gains of the stimulus package in real GDP (RMB trillion) 2007-15

In short-run, according to research model that without government stimulus package, although the financial crisis just a short phenomenon, but China economy will need longer time to recover due to recession. It is a wise step for China government to implement stimulus package as it will not only help in the short-run shock of the crisis, but also lead a rapid growth for the China’s economy after the shock.

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Impact in Medium and Long-term

Although expansionary fiscal policy (stimulus package) able to avoid fall in growth, but for medium and long-term impacts of this expansionary policy is uncertain. China government implement stimulus package in few years before which centered on FAI, and this makes the investment rate has been increasing steadily since 2001. China might face more serious overcapacity of the investment in the future.

China’s stimulus package now concentrated in infrastructure rather than new factories. One of the reasons is due to the overcapacity in China economy, because it will lower down the investment efficiency and falls of the investment efficiency will lead a negative impact on their long-term growth. Furthermore, as we know infrastructure investment take a long time to collect revenue streams because it is long term investment. While only investment in infrastructure without exist of investment in manufacturing capacity means there is no return gains by investment in infrastructure. In the worse case, it may cause not only low efficiency, but also increase in non-performing loans in the future.


China is one of the few countries that responded quickly to the global crisis by implement world’s largest stimulus package as expansionary fiscal policy to push up the economy in late of year 2008 and early of year 2009. Without the stimulus package, economy of China will be effect deeply and takes longer period to recover. As remain one of the focuses side by this stimulus package, domestic demand has play important role towards the economy growth. The stimulus run impact show benefits of growth in short-run and it expected to have larger effect on medium and long-term. There are also negative impacts of the stimulus in long-run growth, and it can be serious if the government fails to tackle and solve the problems.

As conclusion, there are pros and cons when implement the stimulus package, but in China, traditional Chinese philosophy views a crisis also an opportunity. By taking the opportunity of the current global recession and monitoring the process of its growth strategy, China may perform better in the future with a new growth.

Properties industry

Start from 1990’s the economy of China’s having a rapid growth with their GDP growth rate maintain over 8% or even over 10% every year. Construction industry would be the most beneficial industry from a rapid growth in China’s economy, because a rapid growth in economy will usually will come together with more development on Business Park, resident areas, public infrastructure and etc.

The above chart showed the China’s share of global construction spending from year 1990- 2010, and the expectation spending figure until year 2014. From the chart, we can see that China is expected going to replace US and Japan to become the world largest construction spending country after year 2010. It was critically a turning point after the economy of US was harmed by financial crisis in year 2008 and made US economy slow down. However, the stimulus package worth 4 trillion RMB launched by China in year 2008 become the main impact to rebalance the economy and maintain the growth in GDP in China. A huge spending in the infrastructure and society welfare under stimulus package ensures the investment of construction activities in China’s.

The below chart showed that the growth rate of China construction spending from year 1998-2008 and it showed China had a rapidly development on structures, infrastructure, and residential. The main reason for such a speedy development in China is the increase in foreign investment to China due to their cheap labor cost. Therefore, income level of China’s citizen start to increase when there is more job opportunities provided and the modernization city concept bring along a rapid development in infrastructure and residential construction in China.

Significantly we can know that the increase in the construction investment is cause by the increase in the demand for housing or any building. The increase in migration from rural to urban, income level of citizen, foreign investment in China and huge amount of spending by China’s government was expected to increase the demand for housing, business office, and public infrastructure. A higher demand than supply in the market was expected to increase the housing prices and other properties prices in China. An increase the in demand for properties in China will make the demand curve D1 shift to D2, and we expect the supply will not change in short term. Therefore the equilibrium point will move from A to B, and the Price will increase and Quantity also will increase. This situation will cause an increase in price level for properties in China’s and it might cause some problem like inflation. A huge amount of increasing in housing price also will lead to some social problem which the lower income group will not able to buy a house when the housing prices is too high. It will cause a lost balance within high income citizen and low income citizen, so it will create pressures in living and some social problem.

P Graph: Demand and Supply for China Properties Market


D 1



D 2


Commodity Industry

As information, out of the 40% total value of stimulus package launched by China’s was contributed to construction on public facilities and infrastructures development. In a construction project, steel have been taken a significant part no matter in cost or materials used in the building. In this part, we will talk about what are the effects that stimulus package launched bring to commodity industry. Over the past few years, China’s commodity industry was under a rapidly growth trend due to policy of China government to open the China market to the world. The action of the China as a communism country to open their market to worldwide can be proved by China’s joined into WTO in year 2001. The rapid development of China’s economy increase the demand of commodity and it also had changed the commodity industry structure as well.

To have a simple explanation, we decide to use steel as a reference to represent commodity issue that we are talking about. From the above graph, we can see that the after the economic revolution plan of China government in year 1980, the steel products production growth of China showed in a very stable and strong growth rate from year 1980 until now. The production growth achieve maximum in year 2004 and start to reduce and hit the lowest growth rate from year 2007 to year 2008. It proved that the production of the steel products was affected by the global financial crisis during that period, the investment project in China become lesser was the major factor to reduce the demand for steel production thereby it will reduce the steel production as well. However, after the stimulus package launched by China government in year 2008, the steel products production growth rate start to increase to around 18% due to the high demand of steel project from the huge investment of construction project under the stimulus package. In fact, the production of steel materials in China is not sufficient to meet the strong demand for steel product in their country. Part of the steel materials has to import from other countries to satisfy their domestic demand for steel product. Lack of steel raw materials in China created the situation which demands higher than supply, this situation become ever more obvious after the China government launched the stimulus package in year 2008. A higher demand from market and a shortage of supply of steel raw material has push the steel prices to further higher and the additional cost of construction needed is pass to the consumer at the end.

Refer to above graph; we can see that the commodity prices dropped to bottom place on year 2008 due to the less investment activities during that year. However, after the China’s government launched the stimulus package, the commodity prices start to increased. It means that, the stimulus package launched by China’s government taking effect to increase the investment activities and the higher demand of commodity from market lead to the increase in commodity prices. An increase the in demand for commodity in China will make the demand curve D1 shift to D2, and we expect the supply will not change in short term. Therefore the equilibrium point will move from A to B, and the Price will increase and Quantity also will increase. An increasing in commodity price level will increase the pricing pressure in China, because it will bring along inflation, income of the citizen will decrease, and the purchasing power of consumer group will be affected.

P Graph: Demand and Supply for commodity in China




D 2

D 1



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