Expansionary and Contractionary Fiscal Policy

now let's see how the government decides whether to increase aggregate demand with expansionary fiscal policy or decrease it with contractionary fiscal policy. So a lot of big words there. But it's pretty simple what ends up happening here. So the government can change its level of spending our taxes, right? And they're gonna do it in response to the state of the economy. They want to respond to a recession or respond to high inflation. Right? So let's start with the first situation when we have a recession and they want to expand the economy, they want more G. D. P. So in the car when the economy is in a recession, Real GDP is below its potential output. Okay so a recession this is where we have cyclical unemployment right? There is unemployment because of the business cycle and there's low investment, there's there's not a lot of investment going on from the firms as well. Okay so GDP tends to be low in the in a recession. So if we look down on the graph, first look what we have, we have R. A. D. A. S. Model, aggregate demand, aggregate supply. And here we have our long run aggregate supply and this is our short run aggregate supply and aggregate demand here, right? This is our price level. So the general price in the economy. And GDP Real GDP over here. Right. So this is kind of like price and quantity similar to our supply and demand graph. Remember when we studied a D. S. A. D. A. S. Model but we're going to go into it a little bit here. So if it's not totally clear, go ahead, go ahead and refresh the A. D. A. S. Model and come back to this video. Um But what we're gonna do here is we're going to analyze this graph. So our long run aggregate supply, remember this is kind of like the potential output of the economy in the long run, all of our resources will be in play and we'll be producing at our potential GDP. However, in the short run you can notice that our equilibrium here in the short run short run aggregate supply and aggregate demand is below that long run GDP, right? It doesn't reach that long run GDP. So we say we're in a recession. So what is the government gonna do? The government can use expansionary fiscal policy and this is where the government increases spending to stimulate the economy. Remember that the government spending is part of our GDP equation, right? And we want to increase our aggregate demand and aggregate demand. Um and G. D. P. Are very closely related here. So, if government spending increases what we're going to see that the aggregate demand increases the demand in the economy um for goods, right. These are things that who wants these goods, the consumers through consumption, the firm's through investment, or the government through government purchases or foreigners through net exports? Well the government, if the government increases its demand, right? We're gonna see aggregate demand shift to the right. So that's what what the whole goal here is we're trying to get back to that long run equilibrium with the G. D. P. So expansionary while they're expanding they want more GDP. And just so you know, we'll we'll get to that in a second. Let's see how this government increasing spending is going to stimulate the economy by increasing government purchases here. We're increasing that aggregate demand. Just like we just said right the the aggregate demand is going to increase. And like we studied in the aggregate demand, aggregate supply model, we're going to shift it to the right, it's gonna shift it to the right here. So A. D. One becomes A. D. Two. And that's where we are now in the economy after the government increases its spending. So we'll see that we moved from this equilibrium down here are short run equilibrium. Where we had we'll say price level one and G. D. P. One. Well, by shifting aggregate demand to the right with an increase in government spending. Now we're back to this long run equilibrium. Right? So now we've reached that long run equilibrium and we have a higher price level. Right? So by increasing their spending, they're gonna affect the price level by increasing increasing the price level when aggregate demand increases. But we get back to that potential GDP over here and that was their goal to get back to potential GDP. So another way that the government can increase aggregate demand? Well, they increase their government purchases we saw here. Right. But how did we discuss? Another thing fiscal policy does is it affects taxes, right. And taxes will affect our consumption are disposable income and our consumption, like we discussed in the introductory fiscal policy video, so the government can also lower taxes which increases consumption. And we'll have the same general effect here on the graph where we're going to shift to the right or aggregate demand and get back to our long run equilibrium where our aggregate demand, short run aggregate supply and long run aggregate supply. I'll make that star shape. Alright, let's pause here and then let's talk about contractionary fiscal policy in the next video. Mhm.

Alright, so now let's discuss contractionary fiscal policy, this is the opposite of expansionary, so in contractionary fiscal policy, the economy has been booming and we're now experiencing rising inflation and the government wants to keep this inflation under control. So right now, Real GDP is above its potential output. We have over employment in the economy and increasing price levels. What do I mean by over employment? What means some people who would generally not be working are now working because there's so much opportunity um for work and way wages are higher that they're like, hey, I actually I'll work right now or the fact that workers are working overtime because the firms are producing so much the economy is booming so much that workers are working more than they generally intend to. So we have over employment. This is something unsustainable in our economy. So if we go down to the graph here, notice now where our long run aggregate supply is with our short run aggregate supply and aggregate demand. So in this situation are short run equilibrium is beyond our potential output. How is that possible? Well, like I just said, we have this over employment um in the economy there's too much, basically too much happening right now and it's not sustainable. So these this over employment and these, this unsustainably high GDP that's beyond our long run potential. Well, the government's gonna try and tone it back a little bit by decreasing aggregate demand. So through fiscal policy, what they can do is they can reduce their spending to reduce inflation. So this is going to affect just like before it's gonna affect the same equation consumption plus investment plus government spending plus net exports. Again, we're affecting the government purchases here. Okay, and like we just discussed above, they can do they can affect consumption as well through taxes, right? The government can also increase taxes which reduces consumption, right? Just like we've been talking about the higher the taxes are the lower the disposable income and lower money available for consumption. So, through either of these things, they can they can enact contractionary fiscal policy by reducing their spending, increasing taxes and we'll see something similar happening on the graph except now we're going the other way since they're reducing their spending, Well, we're going to reduce our aggregate demand here and it's gonna shift to the right, so we'll find a point here excuse me not shift to the right shift to the left right, we're reducing our government spending, it's going to shift it to the left and we'll find ourselves at this new aggregate demand where we're back in long run equilibrium. So, our first spot right here, our initial short run equilibrium, we were in this place where GDP was too high. GDP was beyond our potential and price levels were high. So we were at this higher price level and the government wanted to reduce that, so they enacted this policy and notice what happened at our new long run equilibrium, we're back at that potential GDP that's sustainable in the long run, and the price levels have decreased, right? So they they can successfully reduce inflation when the economy is too hot in that situation. Alright, so that's the contractionary fiscal policy um similar to expansionary fiscal policy. And if you've studied expansionary and contractionary monetary policy, you'll see a lot of similarities with monetary policy and fiscal policy. So if you've done it before, why don't you guys compare those to see the differences and the similarities there? And if not, you'll get to do that once you get to monetary policy. Alright, let's go ahead and pause here and we'll move on to the next video.