Fiscal Policy and AD-AS Model

Economics: IB Diploma, topic 2.5.2

Fiscal Policy & Aggregate Demand

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

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 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.

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.

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.

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.