Dynamic AD-AS Model: Fiscal Policy - Online Tutor, Practice Problems & Exam Prep

Fiscal policy significantly influences the dynamic ADAS model, particularly through expansionary and contractionary measures. Expansionary fiscal policy, implemented during recessions, involves increasing government spending or cutting taxes to boost aggregate demand and reach potential GDP. Conversely, contractionary fiscal policy addresses rising inflation by decreasing government spending or increasing taxes to lower aggregate demand. Both policies aim to align short-run and long-run aggregate supply with potential GDP, ensuring economic stability and growth over time.

Dynamic AD-AS Model: Expansionary Fiscal Policy

Alright. Now, let's see how fiscal policy plays a role in the dynamic ADAS model. So I want to make a note again. Remember, not everyone needs to learn the dynamic ADAS model. Double-check that you need to be studying this because it's a little more complicated. And if you don't need to know it, you don't need to waste your study time learning this tougher model. So double-check with your professor. I'm going to include it here just in case for you. Alright. Let's talk about expansionary and contractionary fiscal policy in the dynamic ADAS model. So recall when we first studied the dynamic ADAS model that it changed a few of the assumptions of our regular ADAS model. What we're going to see is that, in the long run, basically year over year, everything's going to be increasing. We're going to see increases to our long-run aggregate supply. It's going to shift to the right. Increases to our aggregate, our short-run aggregate supply, and increases to our aggregate demand. Everything is shifting to the right, year over year, just because the economy tends to grow over time. Okay?

So when the economy is in recession, let's start here with expansionary fiscal policy. So when the economy is in recession, well, real GDP is below its potential, right? We're in a situation where we don't reach our potential GDP. So the government can step in and issue some expansionary fiscal policy. The government can increase its spending. And by increasing spending, they increase aggregate demand. Right? Government purchases are part of our aggregate demand. So they're increasing our aggregate demand. And another way they can do it is by cutting taxes. Right? By cutting taxes, it'll increase consumption, which is another way to increase aggregate demand. That's their goal here when they do expansionary fiscal policy, which is to increase aggregate demand. Okay?

We're in this recessionary situation, and the government is going to boost spending to reach our new long-run equilibrium, our potential GDP. So let's look at the graph here and we've got a few steps that are going to happen here in the dynamic model. So what we're going to have is our initial situation here where we start at a long-run equilibrium. And remember, this is the price level, and this is our real GDP right there. So we start at price level 1 here and at GDP 1. And in our dynamic model, everything shifts to the right year over year. Okay?

So what we're going to do is we're going to shift our long-run aggregate supply. So if this is long-run aggregate supply 1, short-run aggregate supply 1, and aggregate demand 1, what we're going to shift our long-run aggregate supply to the right. So it'll be at this new spot right, let's say over here. So year over year, our long-run aggregate supply increases to GDP 2. Okay. So that's our potential GDP there. And what we're going to see is our short-run aggregate supply also shifting to the right. So this would be our new long-run equilibrium right here if aggregate demand can reach that spot as well.

However, what's going to happen is in a recession, aggregate demand doesn't fall short. It's going to fall short just a little bit. And what we're going to have is our aggregate demand increasing not enough here. So we'll have our aggregate demand say increasing, let's say, just this much. So what's going to happen is we're going to move from point a. So notice this will be point a right here. And that was the initial equilibrium at step 1. And then we have our increases like we just drew on the graph. So we had our new short-run aggregate supply and our new aggregate demand and our new long-run aggregate supply. And our short-run equilibrium has not reached our new long-run equilibrium, right? Because our aggregate demand has shifted, but not enough. So we're at this point B in the short run right here. Okay. We're at point B, which is not a long-run equilibrium. Remember, the long-run equilibrium, we want the whole start across, right? All of all of the start to be in one point. So what's going to happen is we're going to have expansionary fiscal policy. Right? The government is going to boost aggregate demand either by increasing their government purchases or cutting taxes to increase spending. So what we'll have is a final curve right here. If they do it all correctly, there will be a 3rd Aggregate Demand curve, another shift to the right, aggregate demand 3, and this is with fiscal policy. That leads us to our equilibrium here. Our long-run equilibrium at point C. Okay? So notice now, we've got the star shape with the short-run aggregates apply, the long-run aggregates apply, and our final aggregate demand curve there. They're all crossing, in a new long-run equilibrium. Okay? So that's the whole point of fiscal policy is to help keep us at our potential GDP. Okay? And to fight a recession or inflationary state. So let's pause here and let's talk about contractionary fiscal policy in the next.

Dynamic AD-AS Model: Contractionary Fiscal Policy

So now, let's look at a situation where we have rising inflation in our dynamic ADAS model. Remember, this is not for everybody. Double check with your professor before you do your dynamic ADAS model here. All right? So when we have inflation, we're basically above our potential, right? As when we've talked about inflation in our regular ABAS model, our short run equilibrium was beyond our long run equilibrium, right? There was too much GDP basically for our potential GDP. Okay? So in these situations, we're going to have to contract the economy. We're going to have contractionary fiscal policy where the government decreases its spending to lower the aggregate demand, right? Now, aggregate demand is too high. And if we lower it, we can get back to our long run equilibrium. Okay? So by decreasing its spending, it's going to reduce inflation and the same effect can be reached by increasing taxes. So by increasing taxes, it'll lower consumption which again affects aggregate demand. Right? That's the whole point here; we're trying to affect aggregate demand to reach our potential GDP. So this is going to be a little bit of the opposite, where before aggregate demand didn't grow big enough. In this one, aggregate demand is going to grow too much. We're going to have increasing prices and then, the contractionary policy is going to pull it back a little bit. Okay?

So we have our original situation just like before with our price level and real GDP, and we were at point A, right? Our original equilibrium. So we've got long run aggregate supply 1, short run aggregate supply 1, and in our dynamic model, everything's going to increase. So we'll have our long run aggregate supply shifting to the right. Whoops, long run aggregate supply 2, and then we're going to shift our short run aggregate supply to the right as well, but in this case, aggregate demand has gone too hot, right? There's been too much of an increase in aggregate demand. So what we're going to have is a big increase to aggregate demand, maybe somewhere way out here, right? Somewhere way out here as an increase to aggregate demand 2. And you could see we've gone beyond our potential GDP, right? This was GDP 1 right here and this is GDP 2, right? That's our potential GDP right there. But we've gone too far. We're beyond that at point B right here, right? So aggregate demand grew too much and passed the new long run equilibrium and our short run equilibrium is up here past it, right? We've passed our potential GDP on this line where short run aggregate supply, long run aggregate supply. We want aggregate demand to cross there as well. So by using contractionary policy, they're going to reduce aggregate demand, right? They want to reduce the aggregate demand in this case. So they're going to pull it back a little bit. They're going to decrease their spending, increase taxes, whatever it might be to get us to our long run equilibrium. And now, we can be at point C. So this is aggregate demand 3 with fiscal policy. Okay? So the fiscal policy brings the aggregate demand back in line, back to our potential GDP. Because notice what happens at this price level. At price level B, we have that inflation, right? We have higher prices than we did at price level A or price level C. So we're trying to combat those high prices, that inflation that was happening. Alright? So that's how contractionary policy works here. You can see the expansionary and contractionary, they're very similar. It's just basically they're opposites of each other. Alright? Let's pause here and let's move on to the next video.

Here’s what students ask on this topic:

What is the role of fiscal policy in the dynamic AD-AS model?

Fiscal policy plays a crucial role in the dynamic AD-AS model by influencing aggregate demand (AD) to stabilize the economy. During a recession, expansionary fiscal policy, such as increasing government spending or cutting taxes, boosts AD to reach potential GDP. Conversely, during periods of high inflation, contractionary fiscal policy, like decreasing government spending or raising taxes, reduces AD to control inflation. These measures help align short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) with potential GDP, ensuring economic stability and growth over time.

How does expansionary fiscal policy affect the dynamic AD-AS model during a recession?

During a recession, expansionary fiscal policy aims to increase aggregate demand (AD) to reach potential GDP. The government can increase its spending or cut taxes, both of which boost AD. In the dynamic AD-AS model, this shifts the AD curve to the right, moving the economy from a short-run equilibrium below potential GDP to a new long-run equilibrium at potential GDP. This helps close the recessionary gap, increasing real GDP and reducing unemployment.

What are the effects of contractionary fiscal policy in the dynamic AD-AS model?

Contractionary fiscal policy is used to combat rising inflation by reducing aggregate demand (AD). The government can decrease its spending or increase taxes, both of which lower AD. In the dynamic AD-AS model, this shifts the AD curve to the left, moving the economy from a short-run equilibrium above potential GDP to a new long-run equilibrium at potential GDP. This helps control inflation by reducing the price level and aligning real GDP with potential GDP.

How do changes in government spending and taxes influence aggregate demand in the dynamic AD-AS model?

Changes in government spending and taxes directly influence aggregate demand (AD) in the dynamic AD-AS model. Increasing government spending boosts AD because government purchases are a component of AD. Similarly, cutting taxes increases disposable income, leading to higher consumption and thus higher AD. Conversely, decreasing government spending or increasing taxes reduces AD by lowering government purchases and disposable income, respectively. These changes shift the AD curve, affecting the economy's equilibrium and helping to stabilize it.

What is the difference between expansionary and contractionary fiscal policy in the dynamic AD-AS model?

Expansionary fiscal policy and contractionary fiscal policy are opposites in the dynamic AD-AS model. Expansionary fiscal policy, used during recessions, involves increasing government spending or cutting taxes to boost aggregate demand (AD) and reach potential GDP. Contractionary fiscal policy, used to combat inflation, involves decreasing government spending or raising taxes to reduce AD and control inflation. Both policies aim to align short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) with potential GDP, ensuring economic stability and growth.