Fiscal policy and aggregate demand relationship

fiscal policy and aggregate demand relationship

AGGREGATE DEMAND ECONOMICS – A COURSE COMPANION Bleak The Microeconomic demand curve shows the relationship between. Definition of Expansionary fiscal policy. This involves the government seeking to increase aggregate demand – through higher government. In the 21st century, the realities of a recessionary economy are more vivid than many of us would probably like. In this lesson, you'll learn how.

fiscal policy and aggregate demand relationship

Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control which can lead to inflation or asset bubbles. Fiscal policy directly affects the aggregate demand of an economy.

Impact of Expansionary Fiscal Policy

Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports. There are two types of fiscal policy: Expansionary Fiscal Policy When an economy is in a recession, expansionary fiscal policy is in order.

fiscal policy and aggregate demand relationship

In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve since government spending creates demand for goods and services. At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest.

Impact of Expansionary Fiscal Policy | Economics Help

The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.

Contractionary Fiscal Policy Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control causing inflation and asset bubblescontractionary fiscal policy can be used to rein it in to a more sustainable level.

If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes.

The Multiplier Effect- Macro 3.9B

A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.

By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.

fiscal policy and aggregate demand relationship

If private investors buy government bonds, they have less to use for private sector investment. Evaluation of expansionary fiscal policy The impact of expansionary fiscal policy will depend on many factors: What else is happening in the economy?

Lower income tax may fail to boost AD if we also have falling house prices and low confidence.

fiscal policy and aggregate demand relationship

For example inthe US tried to cut taxes; in theory, this lower tax should boost spending. However, the economy was also experiencing falling house prices, lower confidence and a shortage of credit; because of all these factors, expansionary fiscal policy was relatively ineffective in promoting rapid economic growth.

Timing of fiscal policy — amount of spare capacity The impact of an increase in AD depends on situation of the economy. A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity e.

Supply side effects of fiscal policy Lower income tax may increase incentive to work Higher government spending on education and training, could increase long-term labour productivity and help the long-term trend rate of economic growth.

Fiscal Policy - Macroeconomics

But, also government spending could be inefficient and wasteful — it depends on what the government spends the extra spending on. Automatic vs Discretionary fiscal policy Automatic fiscal stabilisers. In a recession, the government will automatically spend more on unemployment benefits because more people will be unemployed. Also, in a recession, people pay less income tax because they earn less Discretionary fiscal stabilisers.

Keynesians argue there will not be crowding out if the economy is below full capacity. This argues expansionary fiscal policy can be financed by printing money — so long as inflation is kept within a suitable target.