Question

What are the key differences between how we illustrate a contractionary fiscal policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

Short answer

Contractionary fiscal policy is represented in both the basic and dynamic AD-AS models by a leftward shift of the AD curve. On the other hand, the dynamic AD-AS model, unlike the basic one, allows for ongoing rightward shifts, mimicking continual economic growth and inflation. Thus, in the dynamic model, contractionary fiscal policy would be seen as a slower rightward shift or possibly even as a leftward shift, depending on the degree of fiscal changes.

Step-by-step solution

Discuss Contractionary Fiscal Policy

Contractionary fiscal policy refers to the actions of the government to slow down an economy's growth, probably to combat inflation. This policy usually entails increased taxation and/or decreased government spending.

Depicting Contractionary Fiscal Policy in the Basic AD-AS Model

In this model, an introduction of contractionary fiscal policy results in a reduction in aggregate demand. This is shown by a leftward shift of the AD curve on a graph where the vertical axis is 'Price Level' and the horizontal axis is 'Real GDP'. Less government spending or higher taxes reduces consumers' disposable incomes, lowering their consumption levels and leading to a decrease in overall demand.

Depicting Contractionary Fiscal Policy in the Dynamic AD-AS Model

In contrast to the basic model, the dynamic model incorporates changes over time, including inflation and growth. A contractionary fiscal policy, in this case, would still lead to a leftward shift of the AD curve. However, due to inflation and growth, both AS and AD curves shift to the right over time. Therefore, contractionary policy in this case would be depicted as a slower rightward shift or a possible leftward shift of the AD curve, depending on the degree of policy change.

Highlight the Differences

The key difference lies in how each model illustrates the changes over time. The basic model portrays a static snapshot of the economy, with shifts in AD because of policy changes being instantaneous and isolated. The dynamic model, however, illustrates ongoing rightward shifts in AD and AS due to the economy's continuing inflation and growth. Here, changes in fiscal policy are relative to this ongoing trend rather than being isolated shifts.

Key concepts

Aggregate Demand and Aggregate Supply Model

The Aggregate Demand (AD) and Aggregate Supply (AS) Model is a fundamental concept in economics that helps us understand how the economy operates. This model uses two key curves: the AD curve, which represents the total quantity of all goods and services demanded across all levels at various price levels, and the AS curve, which shows the quantity supplied.

In this setup, when a government enacts contractionary fiscal policies, such as increasing taxes or reducing government spending, the immediate result is a leftward shift of the AD curve. Such actions decrease aggregate demand because less disposable income means consumers cannot purchase as much, leading to reduced consumption overall. This model is often depicted on a graph showing the price level on the y-axis and real GDP on the x-axis.

Dynamic Aggregate Demand and Aggregate Supply Model

While similar to the basic model, the Dynamic Aggregate Demand and Aggregate Supply Model involves a more evolved approach, integrating the effects of time. Over time, both AD and AS curves tend to move as the economy grows, thanks to factors such as technological progress or increased resources.

Unlike static models, the dynamic approach considers ongoing changes like inflation and technological improvement. With contractionary fiscal policy, the AD curve still shifts left, indicating less demand. However, due to ongoing economic growth, both the AD and AS curves typically shift right. This means that the contractionary policy slows down this rightward progression. Changes in the economy are not standalone but relative to these continual shifts.

Inflation

Inflation is an important consideration in both the basic and dynamic models. It represents the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.

When governments implement contractionary fiscal policies, one of the primary goals is to curb inflation. By reducing aggregate demand, price levels can be contained, thus mitigating inflationary pressures. In the dynamic model, inflation is a key factor, as the gradual rise in prices influences how both AD and AS curves shift over time.

Government Spending

Government spending is a critical lever in fiscal policy. It directly influences the level of aggregate demand in an economy. When the government spends less, it is actively reducing demand for goods and services which can lead to slower economic growth.

By decreasing spending, the government aims to manage excess demand that could boost inflation. In the simple aggregate demand and supply model, reduced government spending results in a leftward shift of the AD curve, reflecting lower demand. In dynamic models, this reduction manifests as a slower growth of demand in comparison to the economic trend.

Taxation

Taxation is a tool used to regulate the economy's cash flow by altering personal and corporate spending behaviors. Through taxes, the government has a mechanism to either stimulate or restrain the economy depending on its current state.

In contractionary fiscal policy, taxes are usually raised to reduce disposable income, constraining consumer spending. Consequently, this policy move results in a leftward shift of the AD curve, indicating reduced demand in the economy. In the dynamic model, higher taxes affect how demand grows over time, moderating the impact of ongoing economic expansion by slowing down consumption growth.