2.5.2

Fiscal Policy and AD-AS Model

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Fiscal Policy & Aggregate Demand

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time.

Fiscal policy impacting AD

Fiscal policy impacting AD

  • 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.
Expansionary fiscal policy

Expansionary fiscal policy

  • Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates.
  • Expansionary policy can do this by:
    • Increasing consumption by raising disposable income through cuts in personal income taxes;
    • Increasing investment spending through cuts in business taxes;
    • Increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments.
Expansionary fiscal policy

Expansionary fiscal policy

  • The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP.
  • However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which the LRAS curve shows.
Contractionary fiscal policy

Contractionary fiscal policy

  • Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation.
  • As shown above, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP.
  • Economists sometimes call this an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation.
Contractionary fiscal policy

Contractionary fiscal policy

  • In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.
Jump to other topics
1

Microeconomics

1.1

Competitive Markets: Demand & Suply

1.1.1Markets & Demand1.1.2Diminishing Marginal Returns1.1.3Supply1.1.4Market Equilibrium1.1.5Price Mechanism1.1.6Consumer & Producer Surplus1.1.7IB Multiple Choice - Demand1.1.8IB Multiple Choice - Supply
1.2

Elasticity

1.2.1Elasticities of Demand1.2.2Factors Affecting Price Elasticity of Demand1.2.3Elasticity of Supply1.2.4Price Elasticity of Supply1.2.5IB Multiple Choice - Price Elasticity of Demand1.2.6IB Multiple Choice - Price Elasticity of Supply1.2.7IB Multiple Choice - Other Elasticities
1.3

Government Intervention

1.3.1Indirect Taxes & Subsidies1.3.2Application Question - Taxing Prices or Quantities1.3.3Subsidies & Price Controls1.3.4Deadweight Loss & Government Intervention1.3.5Elasticity & Tax Incidence1.3.6IB Multiple Choice - Government Intervention
1.4

Market Failure

1.4.1Types of Market Failure1.4.2Introduction to Externalities1.4.3Negative Externalities1.4.4Policy for Negative Externalities1.4.5Positive Externalities1.4.6The Deadweight Welfare Loss of Externalities1.4.7Case Study - The Externalities of Education1.4.8Public Goods & the Free-Rider Problem1.4.9Asymmetric Information1.4.10End of Topic Test - Market Failure1.4.11Application Questions - Market Failure
1.5

HL: Theory of the Firm & Market Structures

1.5.1Theory of the Firm & Market Structures
2

Macroeconomics

2.1

The Level of Overall Economic Activity

2.1.1The Circular Flow of Income2.1.2Defining GDP2.1.3Limitations of GDP2.1.4IB Multiple Choice - Economic Indicators2.1.5Business Cycles2.1.6Output Gaps
2.2

Aggregate Demand & Aggregate Supply

2.2.1The Aggregate Demand Curve2.2.2Components of Aggregate Demand2.2.3Shape of the Aggregate Demand Curve2.2.4Shifts in Aggregate Demand2.2.5IB Multiple Choice - Aggregate Demand2.2.6Short & Long-Run Aggregate Supply2.2.7Alternative Models of LRAS2.2.8Equilibrium in the AD-AS Model2.2.9Output Gaps & the AD-AS Model
2.3

Macroeconomic Objectives

2.3.1Introduction to Unemployment2.3.2Limitations of Unemployment2.3.3Types of Unemployment2.3.4Causes & Impact of Unemployment2.3.5Defining Inflation2.3.6Measuring Inflation2.3.7Use of Index Numbers2.3.8The Consumer Price Index2.3.9Consequences of Inflation2.3.10Causes of Inflation2.3.11Inflation & Unemployment Tradeoff2.3.12The Short-Run Phillips Curve2.3.13The Long-Run Phillips Curve
2.4

Economic Growth, Poverty & Inequality

2.4.1Measuring Economic Growth2.4.2Determinants of Productivity2.4.3Economic Growth & Productivity2.4.4Absolute & Relative Poverty2.4.5Inequality2.4.6Inequality 22.4.7Lorenz Curve2.4.8Government Policy on Poverty2.4.9End of Topic Test - Poverty & Inequality2.4.10Application - Inequality & Poverty
2.5

Fiscal Policy

2.5.1Introduction to Fiscal Policy2.5.2Fiscal Policy and AD-AS Model2.5.3Fiscal Policy Lags2.5.4Automatic Stabilizers2.5.5IB Multiple Choice - Fiscal Policy
2.6

Monetary Policy

2.6.1Objectives of Monetary Policy2.6.2Monetary Policy Implementation2.6.3Monetary Policy & AD-AS Model2.6.4Monetary Policy Lags & Pitfalls
2.7

Supply-Side Policies

2.7.1Supply-Side Policies2.7.2Supply-Side Policies 2
3

The Global Economy

3.1

International Trade

3.1.1Globalisation3.1.2Globalisation for LEDCs3.1.3Globalisation for MEDCs3.1.4Comparative Advantage & Trade3.1.5Protectionism3.1.6Arguments for Protectionism3.1.7Arguments Against Protectionism3.1.8End of Topic Test - Globalisation & Trade3.1.9Case Study - Globalisation & Trade
3.2

Exchange Rates

3.2.1Floating Exchange Rates3.2.2Fixed Exchange Rate3.2.3Effect of a Stronger & Weaker Dollar
3.3

The Balance of Payments

3.3.1Balance of Payments3.3.2Balance of Payments 23.3.3FDI & Reducing a BoP Deficit
3.4

Economic Integration

3.4.1Customs Unions & WTO3.4.2Merged Currency
3.5

Terms of Trade

3.5.1Absolute & Comparative Advantage3.5.2Gains from Trade3.5.3Terms of Trade3.5.4IB Multiple Choice - Comparative Advantage & Trade
3.6

Economic Development

3.6.1Factors Influencing Growth & Development3.6.2International Institutions3.6.3Measures of Development3.6.4Barriers to Development3.6.5Case Study - The Bottom Billion3.6.6End of Topic Test - Emerging & Developing
3.7

The Role of Domestic & International Factors

3.7.1Interventionist Strategies3.7.2Development Strategies3.7.3Development Promotion Policies3.7.4End of Topic Test - Growth & Global Development3.7.5Application Questions -Growth & Global Development
3.8

The Role of International Trade

3.8.1International Institutions3.8.2End of Topic Test - Globalisation & Trade
3.9

The Role of Foreign Aid

3.9.1Aid3.9.2Limitations of Aid3.9.3Support for Aid3.9.4Application Questions - Developing Countries

Practice questions on Fiscal Policy and AD-AS Model

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  1. 1
    Which of the following would increase AD?Multiple choice
  2. 2
    Why do reductions in income tax lead to increases in AD? Multiple choice
  3. 3
    Which of the following is a contractionary fiscal policy? Multiple choice
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Introduction to Fiscal Policy

Fiscal Policy Lags