Aggregate demand is defined as the total level of expenditure on domestically produced goods and services by households, firms, governments and foreigners at each general price level for a given period of time, i.e. AD=C+I+G+(X-M).Aggregate supply shows the total output of good and services that domestic firms would like to produce and sell at each general price level for a given period of time.
Under austerity measures, G will decrease, leading to a decrease in AD. Four different AD: AD1, AD2, AD3, AD4 will lead to four states of economy.
Fiscal Policy
Fiscal policy is the use of government spending and/or taxation to influence the level of economic activity through the aggregate demand.
- Contractionary fiscal policy (short-term)
-A rise in income tax reduces disposable income and thereby reduces AD causing it to shift leftwards
-A rise in corporate tax reduces the post-tax returns on investments, hence reducing the level of investment, shifting AD to the left. This offsets the initial increase in AD, thereby reducing demand pull inflation.
This involves decreasing AD.
Therefore the government will cut government spending (G) and / or increase taxes. Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.
Therefore the government will cut government spending (G) and / or increase taxes. Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.