3.6.3 Expansionary and contractionary fiscal policies in order to close deflationary/recessionary and inflationary gaps Notes

Here, we will differentiate between the two types of fiscal policy:

1. Expansionary Fiscal Policy
2. Contractionary Fiscal Policy

Expansionary Fiscal Policy

Expansionary fiscal policies are used to close deflationary gaps by increasing aggregate demand.

1. Observing the diagram above, the economy initially produces at $Y_{rec}$ with $AD_1$, below potential output as $Y_{rec}<Y_p$.
2. The government can enact expansionary fiscal policies, such as:
   1. increase government spending (↑G)
   2. decrease income taxes (causing increase in consumer spending).
   3. decrease in corporate tax (causing increase in business investments).
3. This will cause an increase the aggregate demand from $AD_1→AD_2$ .
4. As a result, the recessionary gap will be eliminated, and the economy will be producing at $Y_p$.

The same effect apples on Keynesian model as well:

When the government uses expansionary fiscal policy, in the Keynesian model:

1. The aggregate demand increases, shifting the curve to the right $AD_1→AD_2$
2. In the first stage (horizontal section), this leads to higher output without increasing the price level.
3. As the economy moves towards the second stage (upward sloping section), output continues to increase, but inflationary pressures begin to rise, causing an increase in price level.
4. This can be observed with $AD_3$ and $AD_4$ as both are on the ends of the second stage.
5. Once the economy reaches the third stage (vertical section), further increases in aggregate demand only lead to higher prices without increasing output, which can be observed with $AD_5$ and $AD_6$.