Fiscal policy and aggregate demand
Trace a policy through spending, output and constraints rather than asserting one guaranteed outcome.
What you will learn
- Distinguish fiscal from monetary policy.
- Explain an expansionary spending change.
Identify the instrument
Fiscal policy concerns government spending and taxation. Monetary policy concerns instruments such as interest rates and the money supply. A change in government expenditure is therefore a fiscal measure.
Aggregate demand comprises consumption, investment, government spending and net exports. Higher government spending, other things equal, directly raises the G component.
Develop a conditional chain
An increase in spending can raise demand for output, prompting firms to expand production and employment when spare capacity is available. Additional incomes can generate further spending, although leakages limit that process.
The final effects depend on productive capacity, financing, import demand and other responses. Near capacity, extra demand may increase prices more than real output. A good evaluation states which conditions make an effect more likely.
Worked example
A government increases infrastructure spending while leaving taxes unchanged. Explain the likely demand-side direction.
Show the worked solution
- Government spending G rises directly.
- Other things equal, aggregate demand rises.
- This is an expansionary fiscal change, though its size and effects depend on the economy's conditions.
Answer Expansionary fiscal policy
Common mistakes
- Do not call a spending change monetary policy.
- Higher demand does not guarantee equal increases in real output.
What can you explain now?
Why might expansionary policy cause more inflation when there is little spare capacity?
Compare with the explanation
Output cannot readily expand to meet the extra demand
Pressure on scarce productive resources can raise costs and prices.
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