Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Impacting demand via fiscal policy


Fiscal policy refers to government policy as it relates to government expenditure and taxation. Fiscal policy matters because it determines how much tax everyone in an economy pays and what goods and services the government provides for the country and its people. Changes in fiscal policy have the potential to cause large impacts on the economy.

Fiscal policy impacts aggregate demand. As such, changes in fiscal policy are considered ‘shocks’ in the AD–AS model. We discuss fiscal policy in detail in Chapter 11, but here we take a look at it in the context of the AD–AS model and shocks.

Expansionary fiscal policy


Expansionary fiscal policy is an increase in government expenditure

or a decrease in taxation. Either of these policy changes affects the economy by increasing aggregate demand.

Government expenditure (G) is a component of aggregate demand (AD = C + I + G + NX) (see the earlier section ‘Testing your faith: Confidence in the economy’), so any increase in G directly leads to an increase in AD. A reduction in taxes also impacts on AD through two main mechanisms:

Increased consumption (C): Consumption is highly influenced by the amount of disposable income people have (that is, income after tax, Y – T). By reducing taxes in an economy, the government increases

disposable income. When people have more disposable income, they consume more.


Increased investment (I): When firms make investment decisions, one of the key things they want to know is how much of any future profit they’re likely to be able to keep. The more they can keep, the more they want to invest in capital goods today. Thus lower taxes boosts investment today.

Whether the reason is due to an increase in G or a fall in T (or both), the impact on the economy is to raise AD (see Figure 9-6). Aggregate demand has increased from AD₁ to AD₂, which in the short run caused output and the price level to rise. You can see this as a movement from point A to point B: because prices are sticky in the short run, the price level hasn’t risen by much. As time passes and prices become more flexible, short-run aggregate supply (SRAS) shifts up and to the left, raising the price level and reducing output until eventually output is unchanged at point C.

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Figure 9-6: Expansionary fiscal policy.

Thus, expansionary fiscal policy gives the economy a short-term boost and raises incomes and reduces unemployment. But this boost is short-lived. After prices adjust, output falls to its natural level and unemployment rises to its natural rate.

Depending on the particular fiscal policy change you’re considering, long-run aggregate supply (LRAS) can increase and shift to the right.
Imagine that the government increases spending on education, leading to a more skilled, more productive workforce and increasing the
natural level of output. Equally, if taxes fall and firms are encouraged to invest more, increasing the capital stock, the natural level of output also increases.