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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.

Problems

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!

References

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

what is microeconomics and macroeconomics
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microeconomic deal with the study of individual firms and household and macroeconomics deal with the economy as a whole.
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definition of Monopoly
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business economics is the way the society uses its limited resources to satisfy their unlimited wants
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demand means desire for a commodity backed by willingness & ability to pay for that commodity
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supply means suppliers supplying more commodities when price's high or less when price's low to satisfy human want
Prince
the coefficient of price elasticity of supply is the measure of percentage change in the quantity supplied of a good due to a given percentage change in its price.
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Please what is Economics of Scales?
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Cardinal utility is the satisfaction derived by the consumers from the consumption of goods and services while ordinal is ranked in terms of preference.
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Economics Economics - The study of how people use their limited resources to try to satisfy unlimited wants
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Economic integration has been one of the main economic developments affecting international trade in the last years. Countries have wanted to engage in economic cooperation to use their respective resources more effectively and to provide large markets for member-countries of the resulting integrate
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Inelastic Demand When consumers are relatively unresponsive to price changes. A PED coefficient of less than one means that a particular change in the price of a good will be met by a proportionally smaller change in the quantity demanded.
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demand refers to goods and services that a consumer is willing and able to buy at given rate over a given period of time
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Demand  - The entire relationship between the quantity of product that buyers wish to purchase per period time and the price of that product..
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what measures are necessary to the economy which is not doing fine
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must find out the problems originating from and take remedy for it.
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Economics as a social science Discuss
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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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