Question

Use the AD/AS graphical framework to show the effect of expansionary fiscal policy on the level of output, prices and the interest rate in the short run and the long run.

Answer 1

INTEREST EFFECT

PRICE AND OUTPUT EFFECT

MAIN ANSWER :

Fiscal policy is the use of government spending and taxation to influence the economy.

• The government has two levers when setting fiscal policy: it can change the levels of taxation and/or it can change its level of spending.
• In expansionary fiscal policy, the government spends more money than it collects through taxes.
• In contractionary fiscal policy, the government collects more money through taxes than it spends.

1. IN THE SHORT RUN :

• Effect on output and price :

The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand.

The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.

• Effect on interest rate :

Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

2. IN THE LONG RUN :

• Effect on output and price :

Expansionary fiscal policy will lead to higher output today, but will lower the natural rate of output below what it would have been in the future. The same happens with price.

• Effect on interest rate :

A fiscal expansion affects the output level in the long run because it affects the country’s saving rate. The country’s total saving is composed of two parts: private saving (by individuals and corporations) and government saving (which is the same as the budget surplus). A fiscal expansion entails a decrease in government saving. Lower saving means, in turn, that the country will either invest less in new plants and equipment or increase the amount that it borrows from abroad, both of which lead to unpleasant consequences in the long term. Lower investment will lead to a lower capital stock and to a reduction in a country’s ability to produce output in the future. Increased indebtedness to foreigners means that a higher fraction of a country’s output will have to be sent abroad in the future rather than being consumed at home.