Fiscal Policy

Unit 12 - Lesson 2

Learning outcomes:

Explain how changes in the level of government expenditure &/or taxes can
influence the level of Aggregate Demand.
Describe the mechanism through which expansionary fiscal policy can help
an economy close a recessionary gap.
Construct a diagram to show the potential effects of expansionary fiscal
policy, outlining the importance of the Aggregate Supply curve.
Describe the mechanism through which contractionary fiscal policy can help
an economy close an inflationary gap.
Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the Aggregate Supply curve.

Macroeconomic Objective
The Macroeconomic Objective of an
economy is to:
1. Stable Price Levels
2. Full Employment
3. Economic Growth
Where:
Actual output = Potential output
Unemployment = NRU

Tragakes, pg. 253

Fiscal Policy
Manipulation by the government of its expenditures and taxes
in order to influence Aggregate Demand.
Fiscal Policy can influence 3 of the 4 components of
Aggregate Demand:
1. Government Spending - G
2. Consumption Spending - C - changes in taxes
3. Investment Spending - I - changes in taxes

Expansionary Fiscal Policy

Economy is experiencing a Recessionary Gap:

Actual Output < Potential Output

Unemployment > NRU

Expansionary Fiscal Policy

Goal is increase Aggregate Demand in order to achieve Full

Employment:
AO = PO
Unemployment = NRU

Policies may consist of:

1.
2.
3.

Increasing Government Spending

Decreasing Personal Income Taxes
Combination of both

Tragakes, pg. 322

Contractionary Fiscal Policy

Economy is experiencing an Inflationary Gap

Actual Output > Potential Output

Unemployment < NRU

Contractionary Fiscal Policy

Goal is to decrease Aggregate Demand in order to reach Full
Employment

AO = PO
Unemployment = NRU

Policies may consist of:

1.
2.
3.

Decreasing Government Spending

Increasing Taxes
Combination of both

Tragakes, pg. 342

Ratchet Effect
Ratchet Effect

Price Levels increase when there is an

increase in AD and economy experiences an
Inflationary Gap.
Though when there is a decrease in AD,
Price Levels will remain the same and Real
GDP will decrease.
This is a more realistic representation of what
happens in the real world.

Tragakes, pg. 342