The Tools of Fiscal Policy

Government purchases are a direct piece of aggregate demand, so when the government buys more highways, teachers' salaries, or military equipment, that spending adds straight to AD and shifts it rightward. Taxes work indirectly: cut taxes and households keep more income, and they spend part of that extra income based on their marginal propensity to consume, which also pushes AD right, just by a smaller amount per dollar than spending does, since some of the tax cut leaks into saving. Raise taxes or cut spending and both effects run in reverse, pulling AD back left.

Expansionary fiscal policy raises spending or cuts taxes to fight a recession, shifting AD right to close a negative output gap. Contractionary fiscal policy raises taxes or cuts spending to fight inflation, shifting AD left. Contractionary does not mean spending drops to zero. It means spending or taxes move in the direction that shrinks AD relative to whatever baseline the economy was on, even if the government is still spending trillions overall.

Where this sits in the bigger model matters: if the economy is already at full employment output on the long-run aggregate supply curve, an extra burst of expansionary policy cannot create more real output in the long run. The AD shift still raises output and prices in the short run, but as wages and input costs adjust, short-run supply shifts left and output settles back at potential, leaving only a higher price level, a preview of why fiscal policy has limits and why the long-run supply curve is vertical.