Expansionary Policy – Fiscal and Monetary Impact on ADSL
MacroeconomicsThis diagram illustrates how expansionary fiscal or monetary policy shifts aggregate demand (AD) rightward, increasing real GDP and the price level.
Curves and elements
- ad1
- AD1: Initial aggregate demand before expansionary policy.
- ad2
- AD2: Aggregate demand after expansionary fiscal or monetary policy.
- sras
- SRAS: Short-run aggregate supply curve, assumed unchanged.
- lras
- LRAS: Long-run aggregate supply, vertical at full employment output.
- pl1
- PL1: Initial price level before policy intervention.
- pl2
- PL2: New, higher price level after AD increases.
- y1
- Y1: Full employment level of output achieved through policy intervention.
Key explanations
- 1
Expansionary policy is used to close a deflationary or recessionary gap by increasing aggregate demand (AD).
- 2
Initially, the economy is in equilibrium at AD1, SRAS, and price level PL1, with output at full employment (Ye).
- 3
A shift to AD2 represents the effect of expansionary fiscal policy (increased government spending or tax cuts) or monetary policy (lower interest rates, increased money supply).
- 4
This leads to a new equilibrium with higher output at full employment (Y2) and a higher price level (PL2).
- 5
The diagram demonstrates the short-run effects of policy tools on output and inflation.
Example exam question
Using an AD/AS diagram, explain how expansionary fiscal or monetary policy can be used to close a deflationary gap.
Show example answer
In the AD/AS diagram, expansionary policy shifts AD rightward from AD1 to AD2. This can be achieved through fiscal tools (e.g., tax cuts, increased government spending) or monetary tools (e.g., interest rate cuts). The result is higher real GDP and a higher price level as the economy moves toward full employment output (Y1).
