Fiscal policy affects aggregate demand and economic activity through taxes and government spending changes. For example, tax cuts increase aggregate demand and stimulate economic growth.
Unlike businesses and households, taxes and spending changes are at the government’s discretion. For example, the government may intentionally cut taxes during a recession. This decision is expected to stimulate aggregate demand and increase economic activity.
Meanwhile, it is difficult for the economy to rely on the business and household sectors to recover activity. Both sectors tend to save money during a recession as rational economic actors. For example, businesses cut investment and take efficiency measures during this period because their profitability is depressed. Likewise, the household sector reduces consumer spending and saves more as they see deteriorating income and employment prospects. For this reason, Keynesian economists advocate for governments to intervene to get the economy out of recession.
What is fiscal policy?
Fiscal policy is economic policy to influence the economy through changes in the government budget. The two fiscal tools are:
The government modified both to achieve macroeconomic goals such as high economic growth rates, low and stable inflation, and low unemployment rates. While government spending directly impacts aggregate demand, taxes have an indirect effect. For example, changes in taxes affect changes in household disposable income, which in turn affects aggregate demand.
What is aggregate demand?
Aggregate demand represents the total expenditure by the four sectors in the macroeconomy. They are household consumption, business investment, government spending, and net exports.
- Aggregate demand = Consumption + Investment + Government spending + Net exports
Economists identify several factors influencing aggregate demand. The price level is the first. Other factors are consumer and business confidence, exchange rates, household wealth, fiscal policy, and monetary policy.
Unlike the price level, changes in those factors cause the aggregate demand curve to shift to the right or left. Meanwhile, a change in the price level causes a change in aggregate demand, but it moves along the curve.
Then, shifting the aggregate demand curve to the right leads to an increase in real GDP, as economists show in short-run macroeconomic equilibrium. An increase in real GDP indicates the economy is growing and producing more output.
Conversely, a leftward shift of the aggregate demand curve leads to a decrease in real GDP. Economic output is declining.
And in general, shifts in the aggregate demand curve have far-reaching effects. It doesn’t just affect real GDP. But, it also impacts the inflation rate and unemployment rate. This is why governments modify fiscal policy to achieve macroeconomic goals.
How does fiscal policy affect aggregate demand and the economy?
Economists divide fiscal policy into two categories based on the objectives achieved. They are:
- Expansionary or loose fiscal policy
- Contractionary or tight fiscal policy
Expansionary fiscal policy aims to stimulate economic growth. Therefore, the government runs it during a sluggish economy or recession.
Meanwhile, contractionary fiscal policy aims to moderate inflationary pressures. High inflationary pressure creates instability in the economy. That’s because the economy overheats, causing the purchasing power of money to fall. If not moderated, the situation could lead the economy to hyperinflation, where the purchasing power of money falls rapidly. Unfortunately, contractionary fiscal policy also has a negative impact because it weakens economic growth.
Expansionary fiscal policy
The government implements an expansionary fiscal policy by:
- Cut taxes
- Increase spending
The government may take both options simultaneously when it deems necessary. As a result, if previously the government budget was in deficit, this policy will cause the deficit to be higher. And to cover the shortfall, the government will increase debt, for example, by issuing debt securities.
If the policy is successful, a tax cut or an increase in government spending will increase aggregate demand. As a result, the curve shifts to the right, leading to higher real GDP.
An increase in real GDP indicates the economy is producing more output. As a result, businesses increase their production and recruit more workers. Thus, the next impact is a decrease in the unemployment rate.
Tax cuts have an indirect impact on aggregate demand. As we saw in the formula above, tax is not defined as an item in aggregate demand. Rather, it affects demand in the economy, for example, through its impact on household spending and business investment.
Tax cuts leave households with more money. This is because they pay less to the tax authorities. In economic terms, reducing taxes increases their disposable income, which can be allocated to two purposes: consumption and saving.
How much tax cuts impact aggregate demand depends on how much extra money in disposable income they spend on consumption. The more money they spend on consumption, the bigger the impact on aggregate demand.
An increase in household consumption increases the demand for goods and services. The business then responds to this situation by increasing production. Initially, they may rely on existing production facilities and labor. Then, they start investing and recruiting more workers if demand grows strongly.
Increase in government spending
Changes in government spending have a direct impact on aggregate demand. Thus, if the government allocates more spending, aggregate demand increases, prompting real GDP to grow higher.
Increased government spending could create a multiplier effect on the economy. For example, the government increases infrastructure spending to build roads. It does not just create direct demand for goods and services related to construction. But, it also creates jobs and income for households, further increasing aggregate demand. As a result, government spending causes a larger increase in aggregate demand – and final GDP – than the initial injection.
The multiplier effect works when the economy’s output is still below potential output. Thus, there is spare capacity in the economy.
However, suppose the economy’s output is at its potential. In that case, increasing government spending will result in a crowding-out effect. Inflationary pressures rose sharply because the increase made the economy operate beyond its productive capacity (real GDP exceeds potential GDP). As a result, interest rates increase, reducing the business sector’s incentive to invest.
During high inflation, the central bank intervenes in the economy by raising interest rates to moderate inflation. In addition, the government has to take on more debt as the deficit increases due to increased spending. That increases the default risk and forces investors to demand higher interest to compensate for the increased risk. Long story short, this situation leads to high-interest rates in the economy.
High-interest rates make businesses pay more when financing investments. For example, they have to pay higher coupons when issuing debt securities. As a result, investing becomes less viable, reducing their capital expenditures.
Thus, increasing government spending does not always produce a strong multiplier effect when the economy operates at its potential output. Meanwhile, the net effect on the economy depends on which is more significant: a decrease in business investment or an increase in government spending.
Contractionary fiscal policy
The government implements contractionary fiscal policy through:
- Tax increase
- Decrease in government spending
Both options lower aggregate demand, either directly or indirectly. This decrease in aggregate demand results in a leftward curve shift, leading to lower real GDP. As a result, this policy not only moderated inflationary pressures as the price level declined. But, it also weakens economic growth. If policies are too aggressive, it could lead the economy into recession and lead deflation.
There are several options for a tax increase, such as raising:
- Personal income tax to reduce households’ disposable income.
- Indirect taxes, such as excise and value-added taxes, reduce real income.
- Corporate tax to reduce retained earnings.
An increase in taxes reduces aggregate demand indirectly. For example, it reduces internal capital for business investment. Companies must pay more to the tax authorities, reducing retained earnings as internal capital.
Meanwhile, if levied to the household sector, it, for example, reduces consumption by reducing disposable income. The impact of a reduction in consumption spending depends on how much extra disposable income is spent instead of saving. Suppose households spend more of their extra money. In that case, an increase in taxes results in a large reduction in consumption and aggregate demand.
Then, an increase in taxes can also impact a decrease in real income. For example, if the government raises the value-added tax, the price of goods becomes more expensive. As a result, households get fewer goods for the same amount of money than before. As a result, they reduce spending on consumption.
Government spending cuts
Government spending cuts reduce aggregate demand. Unlike taxes, cuts have an immediate impact because government spending is a contributor to aggregate demand. For example, the government allocates less for infrastructure spending. As a result, the demand for related goods and services also falls.
But spending cuts may have another impact. For example, spending cuts could result in increased logistics costs because, without maintenance, infrastructure deteriorates. Finally, rising logistics costs weigh on business activity.
In addition, cuts in items such as education spending could have an impact in the long term through their effect on the workforce quality.
Some economists also argue the cuts lead to more private investment. For example, the government can reduce debt by issuing less, supporting lower interest rates in the economy. This situation provides an incentive for the private sector to invest.
What to read next
- Aggregate Demand Curve: Meaning, Sloping Reasons, Determinants
- Aggregate Demand: Formula, Components and Determinants
- Business Confidence: Its Effect on Aggregate Demand and the Economy
- Capacity Utilization: Its Relationship With Profitability, Aggregate Demand and the Economy
- Consumer Confidence: Its Effect on Aggregate Demand and the Economy
- Demand Shock: Definition and a Brief Explanation
- How Exchange Rates Affect Aggregate Demand and the Economy
- How Fiscal Policy Affects Aggregate Demand and the Economy
- How Household Wealth Affects Aggregate Demand and the Economy
- How Monetary Policy Works Affects Aggregate Demand and the Economy