Exploring Fiscal Policy: Impact on Aggregate Demand and Growth

This essay provides a comprehensive overview of fiscal policy, a macroeconomic tool used by governments to achieve various economic objectives. It begins by introducing the concept of fiscal policy, highlighting its two main instruments: taxation and government expenditure. The essay discusses the historical context, referencing John Maynard Keynes's advocacy for government intervention to stabilize the economy. It elaborates on discretionary fiscal policy and automatic stabilizers, explaining how these mechanisms function during economic fluctuations. Furthermore, the essay outlines the three stances of fiscal policy: expansionary, contractionary, and neutral, detailing the conditions under which each is employed and their respective impacts on aggregate demand and economic activity. Finally, it differentiates between the short-run and long-run objectives of fiscal policy, emphasizing the focus on macroeconomic stability in the short term and sustainable economic growth in the long term. Desklib offers a variety of solved assignments and study tools to aid students in understanding complex economic concepts.

Running Head: ECONOMIC ASSIGNMENT
Economic Assignment
Name of the Student
Name of the University
Course ID

1ECONOMIC ASSIGNMENT
Fiscal policy is one instance of macroeconomic policy used by the government to achieve
different policy objectives. The fiscal policy suggests use of two main tools of taxation and
government expenditure in order to influence economic activity. John Maynard Keynes first
proposed intervention of government to stabilize the economy. Government often uses fiscal
policy to stabilize state of the economy in the phase of business cycle fluctuation. The
adjustment made through altering taxation and government expenditure, government can
influence key macro variables such as aggregate demand, saving, investment and income
distribution (Agénor and Montiel 2015). The fiscal policy is administered by a group of
government body following a particular law of legislature.
Government uses fiscal policy to counter economic fluctuations. In times when
government takes fiscal action to combat business cycle fluctuation then it is called discretionary
fiscal policy. Discretionary fiscal policy is adapted during rising inflation and level of
unemployment. Another important instrument used under fiscal policy action is automatic
stabilizers. The automatic stabilizers correspond to transfers and taxes that changes automatically
depending upon state of the economy. For example, during economic downturn spending made
on food stamps increases automatically because more people uses it (Mankiw 2014). Addition
spending on food stamp then softens the economic downturn by helping those receiving benefits
from food stamp. The policy automatically helps to expand businesses where money is spent.
The three stances of fiscal policy include expansionary fiscal policy, contractionary fiscal
policy and neutral fiscal policy. Expansionary fiscal policy is undertaken during economic
contraction. This is the time when economic growth slows down along with a decline in price
level and employment. In order to stimulate the economy aggregate demand needs to be

2ECONOMIC ASSIGNMENT
increased. Following economic slowdown, government adapts expansionary fiscal policy either
through increasing government expenditure or through cut in the tax rate. When government
raises expenditure through investment or consumption then thus helps in economic expansion
through an increase in aggregate demand. A reduction in tax rate increase disposable income
leaving more money available for consumption (Blanchard 2018). As consumption spending
increases aggregate demand increases as well. By contrast, contractionary fiscal policy is
undertaken during high inflation. The contractionary fiscal policy is implemented through a
reduction in government expenditure or increase in tax rate. The contractionary fiscal policy
works as opposite to expansionary fiscal policy. This reduces aggregate demand leading to a
contraction of economic activity and price level (Agénor and Montiel 2015). A neutral fiscal
policy is undertaken when the economy is in a stable state that is neither experiencing a boom
nor experiencing a recession.
Objective of fiscal policy differs with time and economic state. In the short run, objective
of the government is to achieve macroeconomic stability with helping the ailing economy to
recover, control inflation and reduce economic vulnerabilities caused by external factors. In the
long run however government targets to foster a steady and sustainable economic growth in
association with supply side policies (Hansen 2014). In the short run, government is more
concerned with economic fluctuations catering to business cycle while the long term objectives
are mostly related with development goals, resource endowment and demographics.

3ECONOMIC ASSIGNMENT
References
Agénor, P.R. and Montiel, P.J., 2015. Development Macroeconomics Fourth edition. Economics
Books.
Blanchard, O., 2018. Distortions in Macroeconomics. NBER Macroeconomics Annual, 32(1),
pp.547-554.
Hansen, B., 2014. The economic theory of fiscal policy. Routledge.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.