Fiscal policy is the tool used by government to control and manipulate the economy. The main tools of fiscal policy are tax rates and government purchases. The government can have either contractionary policy or expansionary policy.
a.Show the AS-AD diagram as follows: In the graph above, it can be seen that when there is decrease in aggregate demand then the demand curve will shift to the left which will decrease the as well as output. And decrease in output reduces employment further.
b.When the demand curve shifts to its left then the real GDP decreases, which means that the overall production of the economy has decreased. When production has decreased then the labor demand will also decrease which will cause higher unemployment rate.
(a) According to the Ricardian equivalence theorem, there would be no effect of deficit spending on the interest rate and private investment. This implies that even if government finance it is spending by selling bonds there would be no increase in interest rates and thus there would be no crowding out of private investment.
Following figure shows the market forAs above figure shows, initiallyNow, government finance it is spending by selling bonds, this selling of bonds implies rise in demand forAs Ricardian equivalence theorem states that if government finance current spending by running deficit that is by selling bonds then, in future, it have to raise taxes so that it can have necessary resources to pay for the interest on the bonds and to repay the bonds when they came to maturity. Furthermore, to pay for the increased taxes in future, people will now consume less and would save more. These savings in anticipation of future taxes will meet the rise in demand forNew equilibrium is attained at point B, where interest rate is R percent per year and quantity ofThus, interest rate has remained same.Since, interest rate has remained same, no crowding out effect has happened and therefore private investment will remain same.(b) According to Ricardian equivalence theorem, there would be no effect of deficit spending on the output in the economy.
This happens because all income accruing to the households and firms from the debt financed government expenditure will be saved in anticipation of future tax burden and thus does not lead to increase in demand for goods and services by households and firms and therefore output in the economy remains same and there is no expansion of aggregate demand.Following figure shows the Goods market - As above figure shows, initially output in the economy is Y. Now, government increases its spending by running deficit that is by selling bonds. This selling of bonds by government to meet its current spending implies that in future taxes will be raised so that necessary resources could be generated to pay the interest on bonds as well as bonds upon maturity. This anticipation of increase in taxes in future will compel the people to decrease their current consumption and increase their current savings so that they would be able to pay the high taxes in future. Thus, increase in government spending will exactly be offset by the equivalent decrease in private spending and hence aggregate demand or aggregate expenditure will remain same and therefore output in the economy remains same.This shown in the above figure by the rightward shift of the aggregate demand curve from AD to AD 1 due to increase in government spending and then back to AD itself due to equivalent decline in private spending.
So, output in the economy has remained same.
FUNCTIONAL FINANCE -
Theory of Functional Finance states that while making spending and taxation decision, government should focus on their effect on the economy as a whole rather than basing its spending or taxing decisions on some moral principles that suggest that government should run balance budgets.
This theory suggest that government should run deficit, if aggregate expenditure in the economy is tooMoreover, functional finance theory acknowledges government budget balance as steering wheel with which economy should be controlled and it is the state of economy that should influence the decision of government to have deficit or surplus.