Economics Micro & Macro (CliffsAP)

A Graphical Analysis of Fiscal Policy

For the AP exam, you will be asked to illustrate the effects of government spending and taxation. You will have to know
what both expansionary and contractionary fiscal policies look like on a graph. First let’s take a look at expansionary
fiscal policy (increased spending and/or decreased taxes).

Figure 5-4 illustrates the effects of expansionary fiscal policy by showing an increase in aggregate demand designed to
meet both the long-run aggregate supply curve and the short-run aggregate supply curve. Any increase of aggregate ex-
penditures (C, I, G, X) will increase aggregate demand. In our illustration, real GDP and the price level both increase.

Figure 5-4

If the government implements a contractionary fiscal policy—raising taxes and/or restricting spending—its goal is to
reduce aggregate demand to prevent demand-pull inflation. Figure 5-5 illustrates a decrease in aggregate demand as a
result of decreased government spending and/or increased taxes. The aggregate demand curve shifts to the left; the price
level and real GDP decrease.

Figure 5-5

Price

Level

LRAS

SRAS

AD^2

P^1

P^2

Real GDP

AD^1

Q^2 Q^1

Price

Level

LRAS

SRAS

AD^1

P^1

P^2

Real GDP

AD^2

Part II: Macroeconomics