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By the end of this section, you will be able to:

  • Explain how expansionary fiscal policy can shift aggregate demand and influence the economy
  • Explain how contractionary fiscal policy can shift aggregate demand and influence the economy

We need to emphasize that fiscal policy is the use of government spending and tax policy to alter the economy. Fiscal policy does not include all spending (such as the increase in spending that accompanies a war).

Graphically, we see that fiscal policy, whether through change in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy    and inward in the case of contractionary fiscal policy    . [link] illustrates the process by using an aggregate demand/aggregate supply diagram in a growing economy. The original equilibrium occurs at E 0 , the intersection of aggregate demand curve AD 0 and aggregate supply curve SRAS 0 , at an output level of 200 and a price level of 90.

One year later, aggregate supply has shifted to the right to SRAS 1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD 1 , keeping the economy operating at the new level of potential GDP. The new equilibrium (E 1 ) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS 2 , and aggregate demand shifts right as well to AD 2 . Now the equilibrium is E 2 , with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

A healthy, growing economy

The graph shows three aggregate supply curves, three aggregate demand curves, and three potential GDP lines. Each aggregate demand curve intersects with an aggregate supply curve and the potential GDP line.
In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E 0 to E 1 to E 2 . Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand.

Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the supply of money, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the supply of money, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

Questions & Answers

A golfer on a fairway is 70 m away from the green, which sits below the level of the fairway by 20 m. If the golfer hits the ball at an angle of 40° with an initial speed of 20 m/s, how close to the green does she come?
Aislinn Reply
cm
tijani
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Siyaka Reply
A mouse of mass 200 g falls 100 m down a vertical mine shaft and lands at the bottom with a speed of 8.0 m/s. During its fall, how much work is done on the mouse by air resistance
Jude Reply
Can you compute that for me. Ty
Jude
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emma Reply
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what is inorganic
emma
Chemistry is a branch of science that deals with the study of matter,it composition,it structure and the changes it undergoes
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Adjanou
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A ball is thrown straight up.it passes a 2.0m high window 7.50 m off the ground on it path up and takes 1.30 s to go past the window.what was the ball initial velocity
Krampah Reply
2. A sled plus passenger with total mass 50 kg is pulled 20 m across the snow (0.20) at constant velocity by a force directed 25° above the horizontal. Calculate (a) the work of the applied force, (b) the work of friction, and (c) the total work.
Sahid Reply
you have been hired as an espert witness in a court case involving an automobile accident. the accident involved car A of mass 1500kg which crashed into stationary car B of mass 1100kg. the driver of car A applied his brakes 15 m before he skidded and crashed into car B. after the collision, car A s
Samuel Reply
can someone explain to me, an ignorant high school student, why the trend of the graph doesn't follow the fact that the higher frequency a sound wave is, the more power it is, hence, making me think the phons output would follow this general trend?
Joseph Reply
Nevermind i just realied that the graph is the phons output for a person with normal hearing and not just the phons output of the sound waves power, I should read the entire thing next time
Joseph
Follow up question, does anyone know where I can find a graph that accuretly depicts the actual relative "power" output of sound over its frequency instead of just humans hearing
Joseph
"Generation of electrical energy from sound energy | IEEE Conference Publication | IEEE Xplore" ***ieeexplore.ieee.org/document/7150687?reload=true
Ryan
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Maurice Reply
what are the types of wave
Maurice
answer
Magreth
progressive wave
Magreth
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Mujahid
A string is 3.00 m long with a mass of 5.00 g. The string is held taut with a tension of 500.00 N applied to the string. A pulse is sent down the string. How long does it take the pulse to travel the 3.00 m of the string?
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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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