MacroeconomicsI_working_version (1)

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Chapter 12
P
AD’
AD
AS
Q*
Q
Figure 12.2 Restrictive (contractionary) fiscal policy. Government decreases its spending or increases
taxes in order to slow down too rapid growth in total demand causing demand-pull inflation.
Restrictive fiscal policy including reduced government spending or increased taxes reduces
total spending, and aggregate demand respectively, and thus, controls inflation. This
process is described in Figure 12.2. A restrictive fiscal action shifts the aggregate demand
curve leftward to reduce total demand and control demand-pull inflation 1 . Government can
combine spending decreases and tax increases to reduce aggregate demand and check
inflation.
12.1.3. Supply-Side Fiscal Policy
The fiscal policy actions may also affect the aggregate supply curve. Particularly, it is the
option of tax changes, which may alter aggregate supply and affect the level of total output
and employment.
Assume the aggregate demand AD and aggregate supply AS are at the equilibrium level
corresponding to the level of real GDP Q 1 and the prices level P 1 in Figure 12.3. Let’s
suppose the government consider the level of employment relating to Q 1 too low.
Therefore it pursuits the expansionary fiscal policy in a form of reduced taxes. It results in
a rise in aggregate demand from AD to AD’ which implies an increase in GDP to Q 2 and
price level to P 2 .
1 By controlling inflation we mean preventing prices from continuous rise bringing them to the initial level.