What effect should expansionary policies have on the aggregate demand and aggregate supply?         

1 Answer

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

In general, expansionary policies, whether they are fiscal or monetary, will cause increases in aggregate demand (AD).  They will not, at least in the short run, cause increases in aggregate supply (AS).

When the government pursues expansionary policies, it is typically affecting the AD curve.  When the government engages in expansionary fiscal policy, it spends more and taxes less.  Both of these factors allow consumers to have more money to spend.  They can also allow businesses to have more money to invest.  Increased consumption and increased investment both affect the AD curve.  They increase AD, causing the curve to move to the right.

Expansionary monetary policies have a similar effect.  When the Fed lowers interest rates or buys government bonds, it makes it easier and cheaper to borrow money.  This means that consumers can borrow to buy consumer goods and businesses can borrow to invest.  Again, it is AD that is affected.

In the long run, such policies can eventually affect AS.  They can allow businesses to invest more.  This investment can eventually lead to greater economic potential overall.  This will shift the AS curve to the right, but it takes a longer time to do this than to affect AD.