Dynamic AD-AS Model: Fiscal Policy

Alright now let's see how fiscal policy plays a role in the dynamic A. D. A. S. Model. So I want to make a note again. Remember not everyone needs to learn the dynamic A. D. A. S. Model. Double check that you need to be studying this because it's a little more complicated and if you don't need to know it you don't need to waste your study time learning this tougher model. So double check with your professor. I'm gonna include it here just in case for you. Alright so let's talk about expansionary and contractionary fiscal policy uh in the dynamic A. D. A. S. Model. So recall when we first studied the dynamic A. D. A. S. Model is that it changed a few of the assumptions of our regular A. D. A. S. Model. What we're going to see is that long run basically year over year, everything's going to be increasing. We're gonna see increases to our long run aggregate supply. It's gonna shift to the right increases to our aggregate our short run aggregate supply and increases to our aggregate demand. Everything is shifting to the right year over year just because the economy tends to just grow over time. Okay so when the economy is in recession, let's start here with expansionary fiscal policy. So when the economy is in recession, well Real GDP is below its potential. Right? We're but we're in a situation where we don't reach our potential GDP so the the government can step in and issue some expansionary fiscal policy. The government can increase its spending and by increasing spending, they increase aggregate demand. Right? Government purchases are part of our aggregate demand. So they're increasing our aggregate demand. And another way they can do it is by cutting taxes right? By cutting taxes, it'll increase consumption which is another way to increase aggregate demand. That's their goal here when they do expansionary fiscal policy is to increase aggregate demand. Okay so we're in this recessionary situation and the government is gonna boost spending to reach our new uh to reach long run equilibrium are potential GDP. So let's look at the graph here and we've got a few steps that are gonna happen here in the dynamic model. So what we're gonna have is our initial situation here where we were going to start at a long run equilibrium and remember this is the price level and this is our real GDP right there. So we started price level one here and at G. D. P. One. Okay. And in our dynamic model everything shifts to the right year over year. Okay. So what we're gonna do is we're gonna shift our uh long run aggregate supply. So If this is long run aggregate supply one short run aggregate supply one and aggregate demand one. Well we're gonna shift our long run aggregate supply to the right so it'll be at this new spot, right let's say over here. So year over year our long run aggregate supply increases To G. d. p. two. Okay, so that's our potential GDP there And what we're gonna see is our short run aggregate supply also shifting to the right so this would be our new um our new long run equilibrium right here. If aggregate demand can reach that spot as well. However what's gonna happen is in a recession, aggregate demand doesn't fall short, it's gonna fall short just a little bit. And what we're gonna have is our aggregate demand increasing not enough here. So we'll have our aggregate demand say increasing let's say just this much. So what's gonna happen is we're gonna move from point A. So notice this will be point A right here and that was the the initial equilibrium and step one and then we have our increases like we just drew on the graph. So we had our new short run aggregate supply and our new aggregate demand and our new long run aggregate supply and our short run equilibrium has not reached our long run equilibrium. Our new long run equilibrium right? Because our aggregate demand has shifted but not enough. So we're at this point B in the short run right here. Okay, we're at point B which is not a long run equilibrium. Remember the long run equilibrium? We want the whole start across right all of all of the star to be in one point. So what's gonna happen is we're gonna have expansionary fiscal policy right um the government is gonna boost aggregate demand either by increasing their government purchases or cutting taxes to increase spending. So what we'll have is a final curve right here. If they do it all correctly, there will be a third aggregate demand curve. Another shift to the right aggregate demand three. And this is with fiscal policy that leads us to our equilibrium here are long run equilibrium at point C. Okay. So notice now we've got the star shape with the short run aggregate supply, the long run aggregate supply and our final aggregate demand curve there. They're all crossing um in a new long run equilibrium. Okay, so that's the whole point of fiscal policy is to help us help keep us at our potential GDP. Okay. And to fight a recession or inflationary state. So let's pause here and let's talk about contractionary fiscal policy in the next video.

So now let's look at a situation where we have rising inflation in our dynamic A. D. A. S. Model. Remember this is not for everybody double check with your professor before you do your dynamic A. D. A. S. Model here. Alright so when we have inflation we were basically at but above our potential right are as when we talked about inflation in our regular A B A. S. Model are short run equilibrium was beyond our long run equilibrium. Right? There's too much GDP basically for our potential GDP. Okay so in these situations we're gonna have to contract the economy, we're gonna have contractionary fiscal policy where the government decreases their spending to lower the aggregate demand right now aggregate demand is too high and if we lower it we can get back to our long run equilibrium. Okay, so by decreasing its spending it's going to reduce inflation and the same effect can be reached by increasing taxes, so by increasing taxes it'll lower consumption which again affects aggregate demand. Right? That's the whole point here is we're trying to affect aggregate demand to reach our potential GDP. So this is gonna be a little bit of the opposite where before aggregate demand didn't grow big enough in this one, aggregate demand is gonna grow too much. We're gonna have increasing prices and then the contractionary policy is gonna pull it back a little bit. Okay so we have our original situation just like before with our price level and real GDP and we were at point a right our original equilibrium. So we've got long run aggregate supply one Short run aggregate supply one and aggregate demand one. Okay, so this is our original situation and then we're gonna have our dynamic increases like we have in our dynamic model, everything's gonna increase. So we'll have our long run aggregate supply shifting to the right, whoops, long run aggregate supply to and then we're gonna shift our short run aggregate supply to the right as well. But in this case, aggregate demand has gone too hot, right? There's been too much of an increase in aggregate demand. So we're gonna have is a big increase to aggregate demand. Maybe somewhere way out here, right somewhere way out here as an increase to aggregate demand to and you can see we've we've gone beyond our potential GDP, right? This was G D. P one right here, this is G D P two, right? That's our potential GDP right there, but we've gone too far. We're beyond that at point B right here. Right? So aggregate demand grew too much and passed the new long run equilibrium and our short run equilibrium is up here past it, right? We've passed our potential GDP on this line where short run aggregate supply, long run aggregate supply, we want aggregate demand to cross there as well. So, by using contractionary policy, well, they're gonna reduce aggregate demand, right? They want to reduce the aggregate demand in this case. So they're gonna pull it back a little bit, they're gonna decrease their spending, increased taxes, whatever it might be to get us to our long run equilibrium, and now we can be at point C. So this is aggregate demand three with fiscal policy. Okay, So the fiscal policy brings the aggregate demand back in line back to our potential GDP because notice what happens at this price level at price level B. We have that inflation, right? We have higher prices than we did at price level A. Or price level C. So we're trying to combat those high prices that inflation that was happening. All right. So that's how contractionary policy works here. You can see the expansionary and contractionary. They're very similar. It's just basically they're opposites of each other. Alright. Let's pause here and let's move on to the next video.