Introduction to Finance

111
General Economic Eff ects of Fiscal Policy 
Economic activity depends largely 
on 
aggregate demand
, which is the total demand for fi nal goods and services in the economy 
at a point in time. An increase in aggregate demand will, generally, cause an increase in 
production and employment but may also cause prices to rise. If the economy is already 
close to full employment, increases in aggregate demand will likely increase prices more 
than output. Similarly, decreases in aggregate demand will result in lower employment and 
reduced prices.
Fiscal policy signifi cantly aff ects aggregate demand and economic activity. Not only is 
government spending itself a large component of aggregate demand, but also, any change in 
government spending has a multiplied eff ect on aggregate demand. An increase in government 
spending increases employment and incomes and, thus, also increases consumer spending. In 
a downturn, not only does spending decrease, but tax receipts of all types—including those 
for Social Security—also decrease when fewer people are at work, because these taxes are 
based on payrolls. Changes in taxes also directly aff ect both disposable income and aggregate 
demand through consumer spending.
Various federal government programs act to stabilize disposable income and economic 
activity in general. Some act on a continuing basis as 
automatic stabilizers
.
 
Other govern-
ment fi scal actions, such as actions taken to continue federal programs that stabilize economic 
activity, are discretionary and depend on specifi c congressional actions. Automatic stabilizers 
include the following:
• Unemployment insurance program
• Welfare payments
• Pay-as-you-go progressive income tax
The unemployment insurance program is funded largely by the states. Under this program, 
payments are made to workers who lose their jobs, providing part of their former incomes. 
Another stabilizer is welfare payments under federal and state aid programs. Both unem-
ployment and welfare benefi ts are examples of