Fiscal Policy and Its Impact on Aggregate Demand and Supply

The essay delves into fiscal policy, specifically its role in influencing aggregate demand (AD) and aggregate supply (AS) within an economy. It uses the context of the United Kingdom’s increasing budget deficit and living standards challenges to illustrate these concepts. Fiscal policies are categorized as either expansionary or contractionary, affecting budget deficits by altering government spending and taxation levels. The essay discusses how fiscal policy impacts AD directly through changes in consumption, investment, government expenditure, and net exports, while its effect on AS is more indirect. It further explores the macroeconomic implications of shifting fiscal policies, noting that increased government spending or reduced taxes boost both AD and AS. Conversely, decreased spending or higher taxes may reduce these aggregates. The conclusion highlights fiscal policy's role in stabilizing economic growth amidst challenges like inflation and unemployment.

Running head: FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND
AGGREGATE SUPPLY
FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND AGGREGATE
SUPPLY
Name of the Student
Name of the University
Author’s Note

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FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND AGGREGATE
SUPPLY
Introduction
This essay highlights on the fiscal policy and its impact on the aggregate demand and aggregate
supply in a particular economy. This topic is analyzed based on the article of UK ‘s budget
deficit that increases this year amid squeezing living standards of people. Fiscal policy denotes
the use of respective nation’s government budget to influence the economy. This mainly includes
government expenditure and levied taxes. Fiscal policy is of two types- expansionary and
contractionary. Expansionary policy increases budget deficit while contractionary policy
decreases budget deficit.
Fiscal Policy influencing aggregate demand and aggregate supply
The article highlights that the government expenditure deficit is going to worsen in the present
year as the figures shows that the slowdown in economy has been starting to take toll on public
finances of UK. It has been stated by some analyst that the UK government will fail in meeting
the plan of decreasing budget deficit each year. Fiscal policy signifies the use of taxing as well as
governments spending powers to impact on economic outcome (Arestis 2012). The fiscal policy
adopted by the government sometimes includes deficit spending in order to enhance aggregate
demand in the respective nation. The budget deficit refers to the shortfall between expenditure of
government and tax revenue. This deficit is basically funded through sale of government bonds
to private sector. Expansionary fiscal policy occurs when expenditure increases or taxes lowers
while contractionary fiscal policy occurs when government spending decreases or tax rises.
However, expansionary fiscal policy increases budget deficit while contractionary policy
decreases deficit (Jaramillo and Cottarelli 2012). In this article, it has been stated that deficit in
UK government spending is going to reduce in this year, which reflects that UK government has

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FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND AGGREGATE
SUPPLY
imposed contractionary fiscal policy in order to combat rising inflation. Implementation of this
policy has also been done for reducing sovereign debt, asset bubbles and out-of-control growth.
Fiscal policy mainly concerns on the change in government expenditure and taxation (Corsetti et
al. 2013). This policy influences both the AD and AS, but the influence on AD is direct while the
effect on AS is indirect. AD refers to the summation of consumption, investment, government
expenditure and net export (AD=C+I+G+(X-M)). Rise in government spending increases AD
that in turn influences the economy. This leads to rise in output as well as prices, considering
other things constant. The degree of rise in price is generally based on elasticity of AS. If AS is
elastic, rise in output results in inflationary pressures. On the contrary, if AS is inelastic, rise in
government spending causes risk of overheating. Some fiscal policy changes can affect the
aggregate supply in direct way, which includes- capital expenditure, R$D innovation etc.
According to the macroeconomic model, if government raises their spending or decreases taxes,
both the aggregate demand (AD) and aggregate supply (AS) of the respective economy increases
and hence shifts to right (Afonso and Sousa 2012). However, this causes the business
organization to expand in the global market and hence enhances the economic growth of nation.
On the other hand, if government reduces spending or increases tax, the aggregate demand will
increase but aggregate supply will decrease. However, AD curve will shift to the right while AS
curve will shift to left. This is shown in the diagram below:

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FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND AGGREGATE
SUPPLY
Real GDP (Y)
Price level
AD1
AD
AS
AS1
P
P1
P2
Y
Figure 1: Contractionary fiscal policy affecting AD and AS
Source: (As created by author)
Conclusion
It can be concluded from the above essay that the government imposes fiscal policy in order to
stabilize the economic growth. The fiscal policy is basically implemented by the government of
the respective nation in order to combat with recession, inflation level and unemployment rate.
Moreover, this policy influences both the AD and AS of the economy which are considered as
the drivers of economic growth.

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FISCAL POLICY AND ITS IMPACT ON AGGREGATE DEMAND AND AGGREGATE
SUPPLY
References
Afonso, A. and Sousa, R.M., 2012. The macroeconomic effects of fiscal policy. Applied
Economics, 44(34), pp.4439-4454.
Arestis, P., 2012. Fiscal policy: a strong macroeconomic role. Review of Keynesian Economics.
Corsetti, G., Kuester, K., Meier, A. and Müller, G.J., 2013. Sovereign risk, fiscal policy, and
macroeconomic stability. The Economic Journal, 123(566).
Jaramillo, L. and Cottarelli, M.C., 2012. Walking hand in hand: fiscal policy and growth in
advanced economies (No. 12-137). International Monetary Fund.