Question

Define fiscal policy. What are the federal government’s three options for conducting expansionary and contractionary fiscal policy? Compare and contrast in detail the effect of expansionary and contractionary fiscal policy on aggregate demand. Draw a graph to illustrate the likely effects.

Answer 1

Fiscal policy is a policy used by government to influence the money supply in the economy. It is a means by which government adjusts its spending levels, transfer payments and monitor tax rates to influence the economy.

The federal government's three options for conducting fiscal policy are :

1. Government spending / Government Expenditure
2. Tax rates
3. Transfer payments

Expansionary fiscal policy : This leads to a decrease in government spending or Increase in tax revenue or a decrease in the transfer payments or a mix of them.

Under the expansionary fiscal policy, the AD curve shifts upwards, showing an increase in the income, employment and output in the economy.

The figure shows LRAS (long run aggregate supply curve ) , SRAS (short run aggregate supply curve) , Aggregate demand (AD). Due to the expansionary fiscal policy, the AD shifts from AD to AD'. The equilibrium shifts from E to E' and the prices increase from P to P'. So, the new level of output in the economy is Y.

Contractionary Fiscal Policy :

This leads to an increase in government spending or a decrease in tax revenue or an increase in the transfer payments or a mix of them.

Under the contractionary fiscal policy, the AD curve shifts downwards, showing a decrease in the income, employment and output in the economy.

The figure shows LRAS (long run aggregate supply curve ) , SRAS (short run aggregate supply curve) , Aggregate demand (AD). Due to the contractionary fiscal policy, the AD shifts from AD to AD'. The equilibrium shifts from E to E' and the prices increase from P to P'. So, the new level of output in the economy is Y.