Fiscal policy in the AS-AD model

Screen 1

In this presentation we look at the impact of fiscal policy in the short and medium run as

reflected by AS-AD model. Make sure that you are familiar with the following:

What is fiscal policy?

Expansionary and contractionary fiscal policy

The AS curve

A movement along an AS curve

Shifts of an AS curve

The AD curve

A movement along the AD curve

Shifts of the AD curve

Short and medium term

Screen 2 Analysing the impact of fiscal policy with reference to the AS-AD model involves tracing

its impact on the goods market, the financial market and the labour market in the short

run, during which the expected price level is fixed, and medium run, during which the

expected price level changes.

The following AS-AD model will be used to explain the impact of an expansionary and

contractionary fiscal policy in the short and medium run.

At point a the price level is P1 and the level of output equals the natural level of output

Yn. At this point the expected price level Pe also equals the current price level P1, and

all our markets are in equilibrium, meaning that in the financial market, the demand for

money equals the supply of money, while in the goods market the demand for goods

equals the output level and in the labour market the bargained real wage equals the

price-determined real wage.

Let’s first deal with the impact of a contractionary fiscal policy which may be the result of

a budget deficit reduction induced by a decrease in government spending or an increase

in taxation to reduce the demand for goods and, therefore, the output level. Let’s

consider the impact of a decrease in government spending as reflected by the AS-AD

model.

In the short run the initial impact of a lower government spending is on the goods market

where decreased government spending erodes the demand for goods and,

consequently lowers output. On the financial market lower output lessens the demand

for money for transaction purposes and the interest rate declines. In turn a lower

interest rate affects the goods market with the result that investment spending increases.

However, the decline in output causes a decline in investment spending which renders

investment spending uncertain. What is not uncertain is that the output level is lower

since government spending is lower. In the labour market lower output erodes

employment and fuels unemployment, thus decreasing the nominal wage and therefore

the price level as well, since prices are determined by a markup over nominal wage

cost.

The AS-AD model reflect this as a leftward shift of the AD curve to a short-run

equilibrium at point b, which in relation to point a, shows a lower price level, due to lower

nominal wages, and the level of output is lower, due to a reduced demand for goods.

Some of our other variables show a lower government spending, which lowers the

demand for goods, thus reducing employment so that unemployment rises causing a

lower nominal wage. The interest rate is also lower due to a decline in the demand for

money.

At point b the current price level P2 , is lower than the expected price level. This

discrepancy between actual and the expected price level will cause the economy to

move into the medium run. Let’s see what happens in the medium run.

Screen 3

In the medium run the expected price level is adjusted downwards by labour. On the

labour market the lower expected price level lowers nominal wage demands, and

therefore the price level decreases. This decrease in the price level spills over into the

financial market where the real money supply increases and the interest rate declines.

In the goods market lower interest rate leads to more investment spending which

increases the demand for goods and therefore output rises.

The AS-AD model reflects the lower wage rate, caused by the lower expected price level

as a downward shift of the AS curve. The change in the financial and goods markets are

shown by a downward movement along the AD curve. This downward shift and

movement along the AD curve continue up to the medium run equilibrium at point c,

where the expected price level equals the actual price level.

One way of looking at the impact of a contractionary fiscal policy in the medium run is to

compare position a, that is before the decrease in government spending, with position c,

that is the medium run position after the decrease in government spending . This we

will do by looking at what happened to the nominal variables and the real variables in the

model.

Screen 4 In this model the nominal variables are: the nominal money supply M, the nominal wage

W and the price level P. The real variables are: government spending, the real money

supply M/P, the interest rate, investment spending, demand for goods, output level

and the real wage.

Let’s see what happens to these variables during the short and medium terms.

In terms of the nominal variables the nominal money supply is the same. The nominal

wage is lower due to a lower expected price level. The actual price level is also lower

due to the lower nominal wage.

In terms of the real variables we will see some changes, unlike the case of monetary

policy where all the real variables were unchanged. Government spending is lower by

assumption, the real money supply is higher due to the decrease in the price level. The

interest rate is lower due to a higher real money supply. The level of investment

spending is higher, due to the lower interest rate. The demand for goods and the output

level first decrease, due to lower government spending and then increase due to more

investment spending, so the economy returns to the natural output level.

Screen 5 In this particular model a contractionary fiscal policy does not change the level of output

in the medium and long run but it does change the composition of the demand for goods

and output level. Government spending is lower and investment spending is higher.

Higher investment spending makes up for lower government spending.

Let’s look at the impact of an expansionary fiscal policy.

Screen 6

An expansionary fiscal policy calls for higher government spending or a decrease in

taxation to increase the demand for goods and the level of output . Let’s consider the

impact of an increase in government spending.

In the short run the initial impact of an increase in government spending is on the goods

market where government spending increases which causes an increase in the demand

for goods and thus the output level rises. On the financial market the increase in output

stimulates the demand for money for transaction purposes, causing a higher interest

rate. The higher interest rate in turn affects the goods market where investment

spending declines. But then the higher output stimulates investment spending and the

change in investment spending is uncertain. It is certain though, that output rises with

increased government spending. In the labour market the higher output level increases

employment so that unemployment falls which exert upward pressure on the nominal

wage and as the nominal wage increases the price level rises, since prices are

determined by a markup over nominal wage cost.

The AS-AD model reflects this as a rightward shift of the AD curve up to a short-run

equilibrium at point b which, in relation to point a, shows a higher price leveldue to the

increase in the nominal wage, and the output level is higher, due to the higher demand

for goods.

Some of our other variables show higher government spending, which stimulates a

higher demand for goods thus raising employment and decrease unemployment which

causes a higher nominal wage. The interest rate is higher due to a greater demand for

money.

At this point the current price level P2 is also higher than the expected price level. It is

this discrepancy between the actual and the expected price level that will cause the

economy to move into the medium run. Let’s see what happens in the medium run.

Screen 7

In the medium run the expected price level is adjusted upwards by labour so that on the

labour market the higher expected price level causes labour to negotiate for a nominal

wage increase, which is followed by an increase in the price level. This increase in the

price level spills over into the financial market where the real money supply decreases

and the interest rate rises. In the goods market the higher interest rate causes a

decrease in investment spending which decreases the demand for goods so that output

falls.

The AS-AD model reflects the increase in the wage rate caused by the higher expected

price level as an upward shift of the AS curve. The change in the financial and the

goods markets are reflected as an upward movement along the AD curve. This upward

shift and upward movements along the AD curve continue until the medium run-

equilibrium position is reached at point c where the expected price level equals the

actual price level.

In terms of the nominal variables the nominal money supply is the same. The nominal

wage is higher due an increase in the expected price level . The price level is also

higher due to the higher nominal wage.

In terms of the real variables we will see some changes, unlike the case of monetary

policy where all the real variables were unchanged. Government spending is higher by

assumption, the real money supply is lower due to the increase in the price level. The

interest rate is higher due to a lower real money supply. The level of investment

spending is lower, due to the increase in the interest rate. The demand for goods and

the output level are unchanged. It first increases due to the higher government

spending and then decreases due to the decrease in investment spending and the

economy returns to the natural level of output. The real wage is also unchanged. The

increase in the nominal wage is offset by an increase in the price level.

In this particular model an expansionary fiscal policy does not change the level of output

in the medium and long run but it changes the composition of the demand for goods and

the output level. The level of government spending is higher and investment spending is

lower. The higher government spending replaces investment spending and crowding

out occurs.