Effects of Different Fiscal Policy Initiatives on Aggregate Demand and Aggregate Supply Curves

A government chooses between two fiscal policy alternatives, an expansionary or a contractionary policy. In an expansionary policy, the government increases its expenditures and/or lowers its tax rates whereas in the contractionary policy the government lowers its expenditure and/or increases its tax rates (Arnold, 2008, p. 235). An expansionary policy is appropriate for periods when the economy is in recession whereas a contractionary policy is appropriate in times of inflation. In case of inflationary gap, aggregate income is quite high (i.e. the real income exceeds potential income) thus individuals demand more of the output resulting into an increase in the price level.

The effect of such policy alternatives on the AD and AS is represented in figure 1. In part a, the figure demonstrates an expansionary fiscal policy. In this respect, the economy is in a recession, with the aggregate demand being represented by the AD0 curve. Once the government implements an expansionary fiscal policy, e.g. increasing expenditure and lowering taxes, the demand curve shifts to the right (the black arrow in part a of the figure) to become AD1. This implies that the government’s actions lead to individuals having more disposable income thus increasing the demanded output hence the AD curve shifts to the right along the horizontal axis. Such increase in demand also leads to a marginal increase in price (P0 increases to P2). Thus, such a policy eliminates the recessionary gap while resulting into a slight increase in the price.

Part b of the figure highlights a contractionary policy, implemented during a period of inflation. At the initial point, i.e. point B, the SAS has shifted upwards thus leading to high price levels; P2 is higher than P0. To avert further inflationary trend that results from upward shift of the SAS, the government embarks on a contractionary fiscal policy. It increases the tax rates and reduces its expenditure. Such action results into a shift of the AD curve towards the left (black arrow in part B). The overall effect of this is a slight decline in the price level and elimination of the inflationary gap.

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In the event where an inflationary gap is not countered through a contractionary policy, the overall effect is that an equilibrium is established at higher price levels. This is evidenced by point C in part b of the figure. In this respect, the SAS curve shift upwards (orange arrow) to reach SAS1. The price level will also increase from P2 to reach P3, while the real output shifts back to Yp (Colander, 2008, p. 219). Accordingly, the economy will have moved from the initial equilibrium, to an equilibrium point at a higher price level i.e. point E.

The effect of the fiscal policy chosen by the government thus arises from its effects on the aggregate demand. An expansionary policy will increase individuals’ real incomes thus enhancing their purchasing power. Increased purchasing power will facilitate the propensity to spend thus enhance aggregate demand. On the contrary, a contractionary policy will decrease the real income; for instance, higher taxes imply that the amounts that individuals get decline. Accordingly, such declines will reduce their propensity to spend thus lowering the aggregate demand. Accordingly, the fiscal policy implemented aims at shifting the AD curve to maintain the output at the potential-output level.

Go to part five.

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