Fiscal policy in the AD-AS model

Overview

Two separate AD-AS effects of a rise in corporation tax.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   In the aggregate demand and aggregate supply model, what is measured on each axis and what does each curve show?

   Model answer

   The vertical axis measures the general price level and the horizontal axis measures real national output, that is real gross domestic product. The aggregate demand curve shows the total planned spending on domestic output at each price level and slopes downwards. Short-run aggregate supply shows the output firms are willing to produce at each price level given current costs and slopes upwards, while long-run aggregate supply shows the economy’s productive capacity and is drawn vertical at full capacity output.

2. 2

   Describe, in terms of curves and equilibrium, the diagram you would draw to show an increase in government spending on public services.

   Model answer

   Draw the general price level on the vertical axis and real national output on the horizontal axis, with a downward-sloping AD curve cutting an upward-sloping SRAS curve at the initial equilibrium, giving price level P1 and output Y1. The rise in government spending increases a component of aggregate demand, so AD shifts to the right from AD1 to AD2. At the new intersection with SRAS the price level has risen to P2 and real output has risen to Y2, so the policy delivers extra output at the cost of some upward pressure on prices.

3. 3

   Describe the AD-AS diagram for a contractionary fiscal policy of higher income tax.

   Model answer

   With the general price level on the vertical axis and real national output on the horizontal, higher income tax reduces disposable income and therefore consumption, so aggregate demand shifts left from AD1 to AD2. Along an upward-sloping short-run aggregate supply curve the new equilibrium lies at a lower price level P2 and a lower level of real output Y2. The policy therefore relieves inflationary pressure but at the cost of lost output and, through derived demand for labour, higher unemployment.

4. 4

   Why does an increase in government spending raise output with very little effect on the price level when the economy has a great deal of spare capacity?

   Model answer

   When large amounts of labour and capital are unemployed, firms can raise production by putting idle resources back to work without having to bid up wages or the prices of inputs, so on a diagram with the general price level on the vertical axis and real national output on the horizontal axis the short-run aggregate supply curve is nearly flat over that range. A rightward shift of aggregate demand along a nearly horizontal aggregate supply curve therefore produces a large increase in real output and only a small rise in the general price level. This is the situation in which expansionary fiscal policy is most attractive.

5. 5

   Analyse, using AD-AS, the effect of a large fiscal stimulus in an economy already operating at full capacity.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the long-run aggregate supply curve is vertical at the economy’s maximum sustainable output and short-run aggregate supply is very steep because further expansion requires firms to bid scarce labour and materials away from one another. The stimulus shifts aggregate demand to the right, but with output unable to rise much the adjustment comes almost entirely through the general price level, which rises sharply from P1 to P2 while real output rises only from Y1 to a barely higher Y2 in the short run and returns to capacity in the long run. The policy therefore buys inflation rather than growth, and it is at this point that a government should be tightening rather than loosening.

6. 6

   A government cuts the basic rate of income tax. Identify the component of aggregate demand affected, the direction of the shift, and the new equilibrium.

   Model answer

   The cut raises disposable income, so the component affected is consumption, and aggregate demand shifts to the right from AD1 to AD2 on a diagram with the general price level on the vertical axis and real national output on the horizontal axis. At the new intersection with the upward-sloping short-run aggregate supply curve, both the price level and real output are higher. The size of the output gain depends on how much of the extra income is spent on domestically produced goods rather than saved or spent on imports.

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