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The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.

Contractionary fiscal policy

Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As shown in [link] , a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD 0 ) and aggregate supply (SRAS 0 ) occurs at equilibrium E 0 , which is an output level above potential GDP. This is sometimes known as 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 AD 1 , and causing the new equilibrium E 1 to be at potential GDP, where aggregate demand intersects the LRAS curve.

A contractionary fiscal policy

The graph shows two aggregate demand curves that each intersect with an aggregate supply curve. Aggregate demand curve (AD sub 1) intersects with both the aggregate supply curve (AS sub 0) as well as the potential GDP line.
The economy starts at the equilibrium quantity of output Y 0 , which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD 0 to AD 1 , leading to a new equilibrium output E 1 , which occurs at potential GDP, where AD1 intersects the LRAS curve.

Again, the AD–AS model does not dictate how this contractionary fiscal policy is to be carried out. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, aggregate demand needs to be reduced.

Key concepts and summary

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.


Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:

  1. A recession.
  2. A stock market collapse that hurts consumer and business confidence.
  3. Extremely rapid growth of exports.
  4. Rising inflation.
  5. A rise in the natural rate of unemployment.
  6. A rise in oil prices.
Got questions? Get instant answers now!


Alesina, Alberto, and Francesco Giavazzi. Fiscal Policy after the Financial Crisis (National Bureau of Economic Research Conference Report) . Chicago: University Of Chicago Press, 2013.

Martin, Fernando M. “Fiscal Policy in the Great Recession and Lessons from the Past.” Federal Reserve Bank of St. Louis: Economic Synopses . no. 1 (2012). http://research.stlouisfed.org/publications/es/12/ES_2012-01-06.pdf.

Bivens, Josh, Andrew Fieldhouse, and Heidi Shierholz. “From Free-fall to Stagnation: Five Years After the Start of the Great Recession, Extraordinary Policy Measures Are Still Needed, But Are Not Forthcoming.” Economic Policy Institute . Last modified February 14, 2013. http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/.

Lucking, Brian, and Dan Wilson. Federal Reserve Bank of San Francisco, “FRBSF Economic Letter—U.S. Fiscal Policy: Headwind or Tailwind?” Last modified July 2, 2012. http://www.frbsf.org/economic-research/publications/economic-letter/2012/july/us-fiscal-policy/.

Greenstone, Michael, and Adam Looney. Brookings. “The Role of Fiscal Stimulus in the Ongoing Recovery.” Last modified July 6, 2012. http://www.brookings.edu/blogs/jobs/posts/2012/07/06-jobs-greenstone-looney.

Questions & Answers

how environment affect demand and supply of commodity ?
Amos Reply
Wht at the criteria for market ?
what is difference between monitory policy and fiscal policy?
Malik Reply
monetary policy is a policy thrust by National Govt(CBN) to influence government spending, purchase &taxes
necessity of economics
Pamela Reply
I will say want,choice,opportunity cost,scarcity,scale of preference
what is monopoly market.How price output are determined under monopoly market
b) Monopoly market is an impecfect market where s single firm having the innovation to produce a particular commodity.Prices are determined through output since there are no other competitive.
Monopoly market:firm has market power & does not respond to market price
Explain the process of price determination under perfect competition market with suitable diagram
bisham Reply
Price determination under perfect competition via this process :firms have no market power to influence price rather firms respond to market price.
price is different from demand- demand is amount of commodity
Effah Reply
demand is amount /quantity of commodity a potential buyer is willing to buy at a given price at market
demand is a desire of customer on commodity with the ability to pay it and willing to buy it at given price of commodity
demand is price of what
Faith Reply
show that shortrun average cost
Baby Reply
what is economics
Mbah Reply
what is money
what is money
Difine macro economics
money is a medium of exchange between goods and services,maybe inform of currency.
Economics is study of how human beings strive to satisfy numerous wants using limited available resources.
how do you find the maximum number of workers the firms should employ order to produce where there are increasing returns
what are implications of computing national income?.
what is the formulae for calculating national income
it calculated by value added method
classify the production units like agriculture, banking, transport etc
money is anything that is generally acceptetable for human
Estimate the net value added(NVA) at fixed cost by each industrial structure
definition of unemployment
Adam Reply
what are the causes of unemployment?
Mbubi Reply
The main causes of unemployment are listed below. 1. Frictional unemployment 2. Cyclical unemployment 3. Structural unemployment
We can also categorize the causes on a broader sense as: 1. Political and 2. Social cause As unemployeement root causes are embaded in this two.
would opportunity cost exist if there was no scarcity?
yes just because the opportunity cost arose when there is Alternative to choose among the alternatives.
I am thinking that, if our resources were unlimited, then there wouldn't be any need to forgo some wants. Hence the inexistence if opportunity cost
politics has done what?
consider time assani
I'm Emmanuel,...I taught the main cause is the change in gov't.
...Lack of capital to set up a firm respectively
I would like to bring in Educational levels can also be the cause the cause of the problem respectively
lack of skills among the new generation is the serious issue.
Where I come from , I don't see why education or personal aspects seem to do with unimployment, technically the motivation and eigerness in all works of live is there , dispite the cultural influence and physical bearriors;the thing we lacking is Government Support and open market ethics.
sorry about that-(repation). We have a over powering ethical political system that's displacing the marketing asspects of economy and causing large scale unemployment right across the board...
can someone Explain Expansionary Monetary Policy and Contractionary Monetary Policy Using one of the instrument of Monetary Policy? Please am kinda lost here?. ta
Emmanuel Reply
using a graph show the case of substitute and compliment goods
Ade Reply
can anyone give me a simple explanation to Five Sector Macroeconomics?
Can someone please define what economics is
jason Reply
economics simply is a social science subject that study human behavior.
economics is a social science which studies human behaviour as a relationship between ends and scarce means that has alternative uses
Can someone please tell me how to calculate GDP
emmanual kapal to calculate GDP (Gross Domestic Product) has three method in calculating it (1)income approach (2) expenditure approach (3) value added method
thanks Alae
u are welcome
in basic terms economics is revered to as battery system, it date back to when Men sees the need to exchange sapless goods and produce to gain , either wealth , basic necessities or to establish trading ties for personal benefit or social asspects in terms of coexistence and continuity, future .
what is the law of demand
Berlinda Reply
keep other thing constant, when the price increases demand decrease when the price decreases demand increases of the commodity.
all things being equal,quantity demanded decrease as price increase and increase as price decrease
there's practial joke to it ..." the higher the demand ; scarcity, increase in production and drop in quality"... quite the controversy - for example China vs Europe, United States and we are all boxed up in between somewhere...
Other thing remain constant the low price of commodity the high quantity of commodity and vice versa is true
Explain Effective demand
Anita Reply
What is effective demand
like Modi is in demand...best example of effective demand
Don't get you
Anita you mean you don't get me or who?
level of demand that represents a real intention to purchase by people with the means to pay

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