Fiscal Policy, Economic Growth, and Productivity ❮ 127
Expansionary Fiscal Policy
When the economy is suffering a recession, real GDP is low and unemployment is high.
In the AD and AS model, a recessionary equilibrium is located below full employment,
as shown in Figure 10.1. If the government increases its spending or lowers net taxes, the
AD curve increases. Net taxes, if you recall, are tax revenues minus transfer payments.
Of course, if the government is using tax cuts, rather than government spending, to expand
the economy, the multiplier is smaller; so to get the same increase in real GDP, the size of
the tax cut must be larger than an increase in government spending.
KEY IDEA
Contractionary Fiscal Policy
If the economy is operating beyond full employment, and inflation is becoming a problem, the
government might need to contract the economy. This inflationary equilibrium is seen beyond
full employment, as shown in Figure 10.2. This can be done by decreasing government spend-
ing or by increasing taxes, both of which cause a leftward shift in AD. The economy should see
a little decrease in real GDP, but ideally a substantial decrease in the rate of inflation.
LRAS
SRAS
AD 0
AD 1
Price
Level
Real GDP
PL 1
PL 0
GDP 0 GDPf
Figure 10.1
Figure 10.2
LRAS
SRAS
AD 0
AD 1
Price
Level
GDPf GDP 0 Real GDP
PL 0
PL 1