Graphing Exercise: Fiscal Policy

Fiscal policy consists of intentional changes in the government’s spending levels or tax policies designed to achieve specific macroeconomic goals such as full employment, price stability, or economic growth.  By influencing the amount of total spending in the economy, the government can influence the position of the aggregate demand curve.  Our theory tells us that aggregate demand will shift by a multiple of the change in spending or taxes.  However, spending and tax changes have slightly different effects, as changes in taxes affect spending only indirectly by changing the amount of disposable income.

An expansionary fiscal policy may be implemented to fight a recession, while a contractionary policy may be appropriate to control demand-pull inflation.

Exploration: How do changes in government spending and taxes affect the equilibrium price level and real GDP?


The graph shows the aggregate demand curve and short-run aggregate supply curve for a hypothetical economy.  The AD curve shows an inverse relationship between the aggregate price level and quantity of real GDP demanded.  The short-run aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP.  To use the graph, change either government spending, tax levels, or both by dragging the sliders located to the right of the graph.  The aggregate demand curve will shift to the left or the right, reflecting the change in spending induced by the change in policy.  In either case, the magnitude of the demand shift depicted is a multiple of the change in spending or taxes, where the tax multiplier is somewhat smaller than the spending multiplier.  Clicking New Equilibrium will illustrate the economy’s adjustment to the new equilibrium.  Click Reset to restore the graph for additional analysis.

  1. Drag the ΔG slider to increase government expenditures by 2.  By how much does the AD curve shift?  What is the value of the multiplier in this economy?  What is the MPC in this economy?
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  2. Click Reset.  Suppose that the economy depicted in the graph is suffering from a recessionary expenditure gap.  That is, suppose that the full-employment level of GDP is higher than Qo, the current equilibrium level of GDP depicted in the graph.  In order to increase real GDP, what changes in fiscal policy may be implemented to restore full employment?  What will happen to the price level as a result?
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  3. Click Reset.  Suppose the government wanted to implement a fiscal policy to increase the equilibrium level of GDP but did not want to expand the size of the deficit.  How might this be accomplished?
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  4. Which is the more expansionary policy—increasing government spending by 5 or reducing taxes by 5?  Why?
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  5. Click Reset.  Suppose that the economy depicted in the graph is suffering from an inflationary expenditure gap.  What changes in fiscal policy may be implemented to restore full employment?
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