Fiscal Policy I

During a recession, the government may use fiscal policy to increase aggregate demand. This includes increasing government spending or cutting taxes.

Consider the graph, where during a recession, the aggregate demand curve AD₁ intersects the short-run aggregate supply curve SRAS₁ at the initial equilibrium, E₁.Here, the output is Y₁.

The long-run aggregate supply curve, or LRAS, shows the level of potential GDP, Y_P. The current output, Y₁, lies below this level.

Suppose the government uses an expansionary fiscal policy and increases spending. It launches several construction projects.

Many unemployed people find jobs and earn income. They spend a portion of their income on purchasing goods and services.

This increases aggregate demand and shifts it to the right.

The output now matches the potential GDP.

Also, the price level rises to P₂, causing inflation along with the expected increase in output.

This example shows how expansionary fiscal policy can shift aggregate demand and help the economy reach potential output.