ADVERTISEMENTS: However, we discuss these measures in brief. Fiscal policy: Controlling aggregate demand is important if inflation is to be controlled. This is sometimes known as an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Now the equilibrium is E2, with an output level of 212 and a price level of 94. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate. In fiscal policy, the government controls inflation either by reducing private spending or by decreasing government expenditure, or by using both. What is the main reason for employing contractionary fiscal policy in a time of strong economic growth? When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. All of the rupees spent on government purchases are injected directly into the spending stream, whereas increased transfers and decreased taxes provide additional income — part of which will be spent but part of which will be saved. What happens to government spending and taxes? Fiscal policy is best described as taxation and spending policies that the government pursues in an effort to influence the overall state of the economy. Explain your answer. Changes in government expenditures 2. As (Figure) shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Changes in taxes and/or government spending to control unemployment or demand- pull inflation are termed fiscal policy. A government is capable of directly affecting economic activity in response to fluctuations in macroeconomic growth. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve. Assuming the government decides to increase the level of income tax, this type of policy will have a wider effect that will affect inflation levels. Fiscal policy uses government spending and tax policies to influence macroeconomic conditions, including aggregate demand, employment, and inflation. Share Your PPT File, Growth Rate of Indian Economy: Top 5 Measures. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap. Good examples are the New Deal and the 2009 Economic Stimulus Program. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. In South Africa, inflation was 5.3%, Argentina 31%, Turkey 16% and Ethiopia 9%. A relationship between the unemployment rate and prices was first prominently established in the late 1950s. Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP. A rise in the natural rate of unemployment. Let us make an in-debt study of the role of fiscal policy in controlling inflation. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. Disclaimer Copyright, Share Your Knowledge Fiscal Policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If the economy is experiencing demand- pull inflation, the appropriate fiscal policy action for lowering the inflation rate is to decrease aggregate spending. Over that time frame, the unemployment rate doubled from 5% to 10%. Chicago: University Of Chicago Press, 2013. Until Great Britain’s unemployment crisis of the 1920s and the Great Depression of the 1930s, it was generally held that the appropriate fiscal policy for the government was to … Fiscal policy—the use of government expenditures and taxes to influence the level of economic activity—is the government counterpart to monetary policy.