Fiscal policy refers to the use of government spending, deficit and tax policies to influence economic conditions.
The Government budget and the total spending
GDP = C + I + G + X – IM
The left-hand side of this equation is GDP, the value of all final goods and services produced in the economy. The right-hand side is aggregate spending, total spending on final goods and services produced in the economy. It is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and the value of exports (X) minus the value of imports (IM). It includes all the sources of aggregate demand.
Fiscal policy that increases aggregate demand, called expansionary fiscal policy, normally takes one of three forms:
• An increase in government purchases of goods and services
• A cut in taxes
• An increase in government transfers
In case of an economy facing a recessionary gap. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, E1, aggregate output is Y1, below potential output, YP. What the government would like to do is increase aggregate demand, shifting the aggregate demand curve rightward to AD2. This would increase aggregate output, making it equal to potential output.
Fiscal policy that reduces aggregate demand, called contractionary fiscal policy, is the opposite of expansionary fiscal policy. It is implemented in three possible ways:
1. A reduction in government purchases of goods and services
2. An increase in taxes
3. A reduction in government transfers
the opposite case—an economy facing an inflationary gap. Again, SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial equilibrium, E1, aggregate output is Y1, above potential output, YP. fiscal policy must reduce aggregate demand and shift the aggregate demand curve leftward to AD2
Broadly speaking, there are three arguments against the use of the expansionary fiscal policy.
• Government spending always crowds out private spending
• Government borrowing always crowds out private investment spending
• Government budget deficits lead to reduced private spending. First of these claims is wrong in principle, but it has nonetheless played a prominent role in public debates. The second is valid under some, but not all, circumstances. The third argument, although it raises some important issues, isn’t a good reason to believe that expansionary fiscal policy doesn’t work.
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