THE EFFECT OF

FISCAL POLICY
ON AGGREGATE
DEMAND
 DEFINITION OF TERMS
• Aggregate demand is a macroeconomic concept calculated as
the aggregated demand for all the produced and finished goods
and services per year.
• It is determined by factors such as consumer spending and
investment, employment and household income, and others.
• It is directly related to the gross domestic product (GDP). It is
the total of produced goods and services per year. Aggregate
demand is the desire for goods and services. Therefore, if the
aggregate demand falls, the GDP falls too.
• Fiscal policy refers to the use of government spending and tax
policies to influence economic conditions, especially
macroeconomic conditions. These include aggregate demand
for goods and services, employment, inflation, and economic
growth
 TYPES OF FISCAL POLICY
• Expansionary fiscal policy are policies enacted by a government that often
increases or decreases the money supply to make changes to the economy. In
other words, governments can directly give money to individuals, businesses,
or taxpayers. Alternatively, to slow the economy, it can take it away.
Examples of expansionary fiscal policy include tax cuts and increased government
spending. Both of these policies are intended to increase aggregate demand
while contributing to deficits or drawing down budget surpluses. Normally,
they're employed during recessions to spur a recovery or amid fears of one.
• Contractionary fiscal policy is when the government either cuts spending or
raises taxes. It gets its name from the way it contracts the economy. It reduces
the amount of money available for businesses and consumers to spend. • The
purpose of contractionary fiscal policy is to slow growth to a healthy economic
level.
The following are examples of contractionary fiscal policies. • Increasing taxes
reduces the money supply and decreases the purchasing power of consumers.
It may also slow down unsustainable production or lower the value of assets. •
Reducing government spending in areas such as subsidies, welfare programs,
FORMULA FOR AGGREGATE
DEMAND
 HOW DOES FISCAL POLICY AFFECT
AGGREGATE DEMAND?

• Fiscal policies influence aggregate demand through government

expenditure and taxation. The more the government spends, the more
would be the aggregate demand. Similarly, if the tax rates are
increased, the aggregate demand would decrease.

• The shift in fiscal policies will impact employment and household income.
This will impact consumer spending and investment, which are
components of aggregate demand.

• Fiscal policy determines government spending and tax rates.

Expansionary fiscal policy, usually enacted in response to recessions or
employment shocks, increases government
spending in areas such as infrastructure, education, and unemployment
benefits.
FIVE DEBATES ON
MACROECONOMIC
POLICY
1.Should monetary and fiscal policymakers try to
stabilize the economy?
Pro: Policymakers should try to stabilize the economy

● The economy is inherently unstable, and left on its own will fluctuate.

● Policy can manage aggregate demand in order to offset this inherent

instability and reduce the severity of economic fluctuations.

● There is no reason for society to suffer through the booms and busts of
the business cycle.

● Monetary and fiscal policy can stabilize aggregate demand and,

thereby, production and employment.
Con: Policymakers should not try to stabilize the economy

● Monetary policy affects the economy with long and unpredictable lags
between the need to act and the time that it takes for these policies to
work.

● Many studies indicate that changes in monetary policy have

● little effect on aggregate demand until about six months after the change
is made.

● Fiscal policy works with a lag because of the long political proces that
governs changes in spending and taxes.

● It can take years to propose, pass, and implement a major change in fiscal policy.

● All too often policymakers can inadvertently exacerbate rather than mitigate the
magnitude of economic fluctuations.

● I t might be desirable if policy makers could eliminate all economic fluctuations, but
2.Should monetary policy be made by rule rather than by
discretion?

Pro: Monetary policy should be made by rule

• Discretionary monetary policy can suffer from incompetence and abuse

of power.

• To the extent that central bankers ally themselves with politicians,

discretionary policy ccin lead fluctuations that reflect the electoral
calendar business cycle. to economic the political

• There may be a discrepancy between what policymakers say they will

do and what they actually do inconsistency of policy. called time
Con: Monetary policy mould not be made by rule

• An important advantage of discretionary monetary policy is its

flexibility.

• Inflexible policies will limit the ability of policymakers to respond

to changing economic circumstances.

• The alleged problems with discretion and abuse of power are

largely hypothetical..

• Also, the importance of the political business cycle is far from

clear
3.Should the central bank aim for zero
inflation?
Pro: The central bank should aim for zero inflation

● Inflation confers no benefit to society, but it imposes several real costs.

 Shoeleather costs
 Menu costs
 ncreased variability of relative prices
 Unintended changes in tax liabilities
 Confusion and inconvenience
 Arbitrary redistribution of wealth

● Reducing inflation is a policy with temporary costs and permanent benefits.

● Once the disinflationary recession is over, the benefits of zero inflation would
Cons: The central bank should not aim for zero
inflation

● Zero inflation is probably unattainable, and

to get there involves output, unemployment,
and social costs that are too high.

● Policymakers can reduce many of the costs

of inflation without actually reducing
inflation.
4.Should the government balance its budget?
Pro: The government should balance its budget

● Budget deficits impose an unjustifiable burden on future generations by

raising their taxes and lowering their incomes.

● When the debts and accumulated interest come due, future taxpayers will
face a difficult choice:

● They can pay higher taxes, enjoy less government spending, or both.

● By shifting the cost of current government benefits to future generations,

there is a bias against future taxpayers.

● Deficits reduce national saving, leading to a smaller stock of capital, which

reduces productivity and growth.
Cons: The government should not balance its budget

● The problem with the deficit is often exaggerated.

● The transfer of debt to the future may be justified

because some government purchases produce
benefits well into the future

● The government debt can continue to rise because

population growth and technological progress
increase the nation's ability to pay the interest on
the debt.
5.Should the tax laws be reformed to encourage saving?
Pro: Tax laws should be reformed to encourage saving

• A nation's saving rate is a key determinant of its long-run economic prosperity.

• A nation's productive capability is determined largely by how much it saves and invests for
the future

• When the saving rate is higher, more resources are available for investment in new plant
and equipment.

• The U.S. tax system discourages saving in many ways, such as by heavily taxing the income
from capital and by
reducing benefits for those who have accumulated wealth.

• An alternative to current tax policies advocated by many economists is a

• consumption tax.

• With a consumption tax, a household pays taxes based on what it spends not on what it
earns.
Con: Tax laws should not be reformed to encourage saving

• Many of the changes in tax laws to stimulate saving would

primarily benefit the wealthy.

• High-income households save a higher fraction of their income

than low-income households.

• Any tax change that favors people who save will also tend to
favor people with high incomes.

• Reducing the tax burden on the wealthy would lead to a less

egalitarian society.

• This would also force the government to raise the tax burden on
THANK
YOU
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