Fiscal Policy

Expansionary Fiscal Policy: Shift AD to the right

  1. increasing government expenditures
  2. increasing transfer payments-increased aggregate demand because this would increase disposable income which would increase consumption.
  3. decreasing taxes-increases aggregate demand by increasing disposable income which means that consumption increases:

Contractionary: Shift AD to the left

  1. decreasing government spending
  2. decreasing transfers
  3. increasing taxes

When are these policies most appropriate?

Discretionary Fiscal Policy- Change in fiscal policy to affect AD intentionally


Deflationary Gap

Output is less than potential output, Q1<Qp..

In the labor market employment is below the nonaccelerating inflation rate of unemployment (NAIRU).

where L1<LN.


  1. Do nothing-the economy will eventually adjust via changes in price expectations which will shift the SRAS so that output achieves Qp.
  2. Use expansionary fiscal policy

. These measures will shift the AD curve to the right so that output is Qp. and the demand for labor will shift to the right as well returning employment to LN.. Historically the US government has used expansionary fiscal policy with some success

B. Inflationary Gap


where Qp<Q0-.


  1. Do nothing-wait for the economy to adjust via changes in price expectations which will shift the short run aggregate supply schedule back and to the left. The long run equilibrium has a higher price level.
  2. Engage in contractionary fiscal policy

which shifts AD to the left and avoids price inflation.


These policies are considered countercyclical. Government policy intended to dampen the swings in the business cycle.

Practical Problems with Countercyclical Policies

1. Government must correctly forecast Qp and the current Q.

2. Economy could change before the government implements policy due to implementation lag.

3. Government might undertake too much or too little action.

Automatic Stabilizers- inherent in the tax and transfer system. These act to dampen the business cycle and provide countercyclical adjustment regardless of discretionary actions undertaken by the fiscal authorities.

A. Inflationary Gap: income (output) and employment are increasing. They are greater than their natural levels. Rising income means that a lower level of transfers goes to the unemployed and low income earners and higher tax payments result due to the progressivity of the tax code. As incomes rise more individuals enter higher and higher tax brackets.

B. Deflationary Gap: Income and employment are falling. They are less than their natural levels. This means that transfer payments increase and tax revenue falls.


Secondary Effects of Discretionary Policy How does the government finance its spending?

A. If government spending increases this has an expansionary effect and AD rises

But if the government increases tax rates to pay for the increase in government spending, this tends to have contractionary effects on AD

Result: Some offset of the expansion.

B. If the government increases government expenditures and borrows money to pay for it then interest rates would be higher than they would have been otherwise.


Crowding out Effect

1. Increasing government expenditures by borrowing increases the deficit which leads to higher interest rates than would have been otherwise, so that investment is lower than it would have been otherwise.

Increasing r may also decrease consumption because it will decrease the number of interest sensitive purchases and will tend to increase savings.

Increasing r may increase the value of the dollar because the number of investors wishing to buy dollar denominated assets will rise since dollar denominated assets will pay a greater rate of interest than did before the increase in r. This increase in the demand for dollars will drive up the value of the dollar relative to other currencies. Now, each dollar will exchange for more of the foreign currencies which means that imports become less expensive and exports are more expensive

these effects tend to offset expansionary policy.


Increasing Interest Payments with Permanent Deficit Spending

a) Assume that we start with a balanced budget and a zero debt

b) r=10%

c) permanently increase spending by $100 billion per year but do not increase tax rates.



Interest Payments























The intention was to run a $100 billion deficit per year which results in larger and larger deficits and debt due to interest payments.