When setting fiscal policy, the government can take an active role in changing its spending or the level of taxation. These actions lead to an increase or decrease in aggregate demand, which is reflected in the shift of the aggregate demand (AD) curve to the right or left respectively .
Expansionary and Contractionary Fiscal Policy
Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left.
It is helpful to keep in mind that aggregate demand for an economy is divided into four components: consumption, investment, government spending, and net exports. Changes in any of these components will cause the aggregate demand curve to shift.
Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two. Since government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right. A reduction in taxes will leave more disposable income and cause consumption and savings to increase, also shifting the aggregate demand curve to the right. An increase in government spending combined with a reduction in taxes will, unsurprisingly, also shift the AD curve to the right. The extent of the shift in the AD curve due to government spending depends on the size of the spending multiplier, while the shift in the AD curve in response to tax cuts depends on the size of the tax multiplier. If government spending exceeds tax revenues, expansionary policy will lead to a budget deficit.
A contractionary fiscal policy is implemented when there is demand-pull inflation. It can also be used to pay off unwanted debt. In pursuing contractionary fiscal policy the government can decrease its spending, raise taxes, or pursue a combination of the two. Contractionary fiscal policy shifts the AD curve to the left. If tax revenues exceed government spending, this type of policy will lead to a budget surplus.