Now we shall look at how specific fiscal policy options work. Decreasing government expenditures and increasing taxes. C). Expansionary and Contractionary Fiscal Policy Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left. b. The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve AS0, at an output level of 200 and a price level of 90. Expansionary Fiscal Policy. Expansionary Fiscal Policy. Expansionary fiscal policy will A) shift the aggregate demand curve to the left. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD 0) to shift right to AD 1, so that the new equilibrium (Ep) occurs at the potential GDP level of 700. Together with the passage of time, the automatic stabilizers help move the economy back to the full-employment level of real GDP sooner than it would have returned on its own.) Contractionary fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left. Natalie, a single mom with four children, lives just down the street from Larry's Limos. Expansionary fiscal policy occurs when the Congress acts to cut tax rates or increase government spending, shifting the aggregate demand curve to the right. An expansionary fiscal policy seeks to shift aggregate demand to AD 2 in order to close the gap. The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. Meet Larry of Larry's Limos of Greater Ceelo. You can view the transcript for “Macro: Unit 3.1 — Types of Fiscal Policy” here (opens in new window). An expansionary monetary and fiscal policy might increase aggregate demand. Aggregate demand to shift left. An increase in government spending or a cut in taxes shifts the aggregate demand curve to the right. The income tax. If the economy is currently producing output of Y0 and the government initiates an expansionary fiscal policy adequate to close the output gap, the result is intended to be A) the vertical line at Y* will shift to the left, intersecting the AS and AD curves at Y0. Expansionary policy can do this by: Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. Which of the following would be the theoretical outcome of expansionary fiscal policy in the following aggregate demand-aggregate supply model (where LRAS - long-run aggregate supply and GDP gross domestic product)? Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Governments can influence aggregate demand by changing government spending and taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession. The shift of the aggregate demand curve from AD1 to AD2 is consistent with: an expansionary fiscal policy. In Panel (b), the economy initially has an inflationary gap at Y1. Aggregate Demand and Budgets The AD curve is shifted by changes in the components of AD (C+I+G+X-M). All of these effects are the inverse of the factors that tend to decrease aggregate demand. ... CF will become negative. Thanks to the recession, she's been laid off as a receptionist and now receives welfare c… The former directly increases aggregate demand, the latter increases aggregate demand by raising household consumption, since household have a higher disposable income due to tax cuts. And if you think about what it would do to these curves, it would shift our aggregate demand curve to the left. ADVERTISEMENTS: Expansionary Fiscal Policy and Monetary under Floating Exchange Rate! Potential GDP can be passed by real GDP only in the. Expansionary Fiscal Policy Shifts The: A) The Aggregate Demand Curve To The Left. The new equilibrium (E1) is at an output level of 206 and a price level of 92. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one. Contractionary monetary policy is enacted to halt exceptionally high inflation rates or normalize the effects of expansionary policy. Expansionary fiscal policy although shifts IS curve to the right but Fiscal policy becomes ineffective in increasing the income level. Now the equilibrium is E2, with an output level of 212 and a price level of 94. Contractionary fiscal policy includes . Fiscal policy means using either taxes or government spending to stabilize the economy. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. Contractionary fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left. Expansionary fiscal policy will. At the equilibrium (E0), a recession occurs and unemployment rises. Expansionary and Contractionary Fiscal Policy: Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left. On the other hand, discretionary fiscal policy is an active fiscal policy that uses expansionary or contractionary measures to speed the economy up or slow the economy down. Look at the figure Fiscal Policy Options. In the real world, however, aggregate demand and aggregate supply do not always move neatly together, especially over short periods of time. One year later, aggregate supply has shifted to the right to AS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. B. aggregate supply curve will shift to the left. a contractionary fiscal policy may be warranted 3.) The shifts labeled A and B show expansionary fiscal policy in action. Expansionary fiscal policy will increase AD, while contractionary will lead to a lower AD. Figure 3. An expansionary fiscal policy will expand the economy's growth. Conversely, increases in aggregate demand could run ahead of increases in aggregate supply, causing inflationary increases in the price level. increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; increasing investments by raising after-tax profits through cuts in business taxes; and. Unemployment insurance. The intersection of aggregate demand (AD0) and aggregate supply (AS0) occurs at equilibrium E0. A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP. D) shift the short-‐‑run aggregate supply curve to the left. B. This can be thought of as the economy contracting. This is achieved by the government through an increase in government spending and a reduction in taxes. A Healthy, Growing Economy. 1 C) Taxes Affect Disposable Income And So Consumption. C. aggregate demand curve will shift to the left. D. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. An alternative measure of expansionary fiscal policy that may be adopted is the reduction in taxes which through increase in disposable income of the people raises consumption demand of the people. Fiscal Policy Affects Aggregate Demand Because: A) Government Spending Is A Category Of Aggregate Demand. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop. Defense spending. Now we shall look at how specific fiscal policy options work. It is helpful to keep in mind that aggregate demand for an economy is divided into four components: consumption, … If the aggregate demand curve is AD'': 1.) What might shift aggregate demand? Expansionary fiscal policy will cause the: A. Without a change in the money demand curve, the interest rate falls. In the diagram, it is assumed that investment, net exports, and government purchases: are independent of the level of GDP. It is helpful to keep in mind that aggregate demand for an economy is divided into four components: consumption, investment, government spending, and net exports. Which of the following would be the theoretical outcome of expansionary fiscal policy in the following aggregate demand aggregate supply model (where LRAS = long-run aggregate supply and GDP = gross domestic product)? technological innovation. D). Which of the following would be the theoretical outcome of expansionary fiscal policy in the following aggregate demand-aggregate supply model (where LRAS - long-run aggregate supply and GDP gross domestic product)? Modification, adaptation, and original content. Expansionary fiscal policies either (1) increase government spending or (2) reduce taxes. 3.33, we have drawn negative sloping IS curve and positive sloping LM curve. Aggregate demand to shift right. Sciences, Culinary Arts and Personal So you would want to get to this aggregate demand curve two through your contractionary fiscal policy. Find out how aggregate demand is calculated in macroeconomic models. The A shift shows a movement from point 3 (a recessionary gap) to point 1, long run equilibrium. Current real GDP is $100. B) shift the aggregate demand curve to the right. Price level (P) LRAS SRAS; SRAS 100 95 90 AD: N AD Real GDP (Y) > The aggregate demand (AD) curve would shift from AD, to AD2. See what kinds of factors can cause the aggregate demand curve to shift left or right. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy. Expansionary fiscal policy includes ---Increasing government expenditures and decreasing taxes. I 5. On the other hand, discretionary fiscal policy is an active fiscal policy that uses expansionary or contractionary measures to speed the economy up or slow the economy down, . The choice between whether to use tax or spending tools often has a political tinge. This could be caused by a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. Figure 1. Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. shift the short-run aggregate supply curve right This makes the LM curve to shift to the rightward direction. D. Short run aggregate supply to shift left. Figure 2. This will increase the demand […] Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and servi… Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small. Expansionary fiscal policy will cause the: C. Short run aggregate supply to shift right. Our experts can answer your tough homework and study questions. We’d love your input. Tightening the money supply discourages business expansion … shift the short-run aggregate supply curve left. An expansionary monetary policy could be an ideal choice in such a sub-optimal situation. As these occur, the government may choose to use fiscal policy to address the difference. In Panel (b), the economy initially has an inflationary gap at Y 1. In Panel (b), the economy initially has an inflationary gap at Y 1. A). It is an expansionary policy if the government increases its spending or cuts taxes. An expansionary fiscal policy seeks to shift aggregate demand to AD 2 in order to close the gap. Falling interest rates increase the quantity of goods and services demanded. the economy is in a recessionary gap shift the aggregate demand curve left. This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. As a result, cut in taxes causes a shift in the IS curve to the right as is shown in Fig. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. Expansionary fiscal policy occurs when the Congress acts to cut tax rates or increase government spending, shifting the aggregate demand curve to the right. Thus, it can be concluded that aggregate output and interest rates have a positive relationship with government expenses, whereas they have a negative relationship with taxes. Earn Transferable Credit & Get your Degree, Get access to this video and our entire Q&A library. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP. Such policies aim to increase output and reduce unemployment. Good work 1 / 1 pts Question 7 Which of the following would not be considered an automatic stabilizer? a. fiscal policy b. monetary policy c. both fiscal and monetary policies d. neither fiscal nor monetary policies . An expansionary monetary policy is needed to stimulate the economy. Monetary Policy: Monetary policy attempts to stabilise the aggregate demand in the economy by regulating the money supply. The economy starts at the equilibrium quantity of output Yr, which is above potential GDP. C) not shift the aggregate demand curve. an expansionary fiscal policy may be warranted 4.) transcript for “Macro: Unit 3.1 — Types of Fiscal Policy” here (opens in new window), https://cnx.org/contents/vEmOH-_p@4.44:T6rLOl1i@4/Using-Fiscal-Policy-to-Fight-R, https://www.youtube.com/watch?v=q-j8AUCLKgw, Explain how expansionary fiscal policy can increase aggregate demand and boost the economy, Explain how contractionary fiscal policy can decrease aggregate demand and depress the economy. 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