27.2 The Effects Of Fiscal Policy On Real GDP And The Price Level

Monetary policy Fed executes monetary policy through changes in interest rates and the money supply Fiscal policy Congress and the president carry out fiscal policy through changes in government purchases and taxes that lead to changes in aggregated demand.

When the economy is in a recession, increases in government purchases or decreases in taxes will increase aggregated demand. Decreases in government purchases or raising taxes can slow the growth of aggregated demand and reduce the inflation rate.

Expansionary fiscal policy involves increasing government purchases or decreasing taxes

Cutting individual taxes will increase households disposable income and consumption spending. Cutting taxes on business income can increase aggregated demand by increasing business investments.

When real GDP is below potential GDP so that some firms operate below normal capacity and some workers have been laid off.

Congress and the president increase government purchases or cut taxes, which will shift the aggregated demand curve to the right. Real GDP increases, price level and GDP rise. Rising GDP and production will lead to increasing employment, reducing the unemployment rate.

The purpose of expansionary monetary policy is to lower interest rates, which in turn increases aggregated demand. When interest rates fall, households and firms are willing to borrow more to buy cars, houses, and factories.

The purpose of expansionary fiscal policy is to increase aggregated demand either by having the government directly increase its own purchases or by cutting taxes to increase households disposable income, and therefore consumer spending.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes.

Policy makers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. When some firms operate beyond their capacity and the unemployment rate stays at a low level, wages and prices will increase. To bring real GDP back to potential GDP, policy makers will decrease government purchases or increase taxes, which will shift the aggregated demand curve to the left so that real GDP and price level reduce.