Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
Learning Objectives
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
Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. At its most basic, fiscal policy operates through increasing aggregate demand (expansionary fiscal policy) or decreasing aggregate demand (contractionary fiscal policy). In this section you will see how expansionary and contractionary fiscal policy affect the economy by looking at both the aggregate demand/aggregate supply model as well as the Keynesian cross model.
Fiscal Policy and Growth in the Aggregate Demand/Aggregate Supply Model
Graphically, we see that fiscal policy, whether through changes 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. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure 1 illustrates.
The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) 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 SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, 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.
Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure 1 shows. Tax revenues then reduce private incomes and hence spending. The result may be an increase in aggregate demand more than