![]() Conversely, increases in aggregate demand could run ahead of increases in aggregate supply, causing inflationary increases in the price level. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. For example, investment by private firms in physical capital in the U.S. Aggregate demand may fail to grow as fast as aggregate supply, or it may even decline causing a recession. This could be caused by a number of possible reasons: households become hesitant about consuming firms decide against investing as much or perhaps the demand from other countries for exports diminishes. In the real world, however, aggregate demand and aggregate supply do not always move neatly together, especially over short periods of time. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E 0 to E 1 to E 2. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.įigure 1. Now the equilibrium is E 2, with an output level of 212 and a price level of 94. One more year later, aggregate supply has again shifted to the right, now to AS 2, and aggregate demand shifts right as well to AD 2. The new equilibrium (E 1) is at an output level of 206 and a price level of 92. One year later, aggregate supply has shifted to the right to AS 1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD 1, keeping the economy operating at the new level of potential GDP. The original equilibrium occurs at E 0, the intersection of aggregate demand curve AD 0 and aggregate supply curve AS 0, at an output level of 200 and a price level of 90. ![]() Contractionary fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left.įigure 1 uses an aggregate demand/aggregate supply diagram to illustrate a healthy, growing economy. On the other hand, discretionary fiscal policy is an active fiscal policy that uses expansionary or contractionary measures to speed the economy up or slow the economy down.Įxpansionary fiscal policy occurs when the Congress acts to cut tax rates or increase government spending, shifting the aggregate demand curve to the right. Automatic stabilizers, which we learned about in the last section, are a passive type of fiscal policy, since once the system is set up, Congress need not take any further action.
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