In what ways can fiscal policy affect aggregate supply?

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Fiscal policy is defined as a governmental instrument used for the stabilization of the macroeconomic aggregates or the complete economic activity in a state. To prevent inflation and decrease the economic activity of the state, the government should run a restrictive fiscal policy. On the other hand, if the economy...

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Fiscal policy is defined as a governmental instrument used for the stabilization of the macroeconomic aggregates or the complete economic activity in a state. To prevent inflation and decrease the economic activity of the state, the government should run a restrictive fiscal policy. On the other hand, if the economy is in a recessive phase, the government should run an expansive fiscal policy.
According to economists, there are three ways in which the macroeconomic variables (such as production, employment. and prices) are influenced by the state’s expenditure and taxes:

  • Aggregate or total demand and supply
  • Accumulation of the state’s assets, funds and resources
  • Motivation

Usually, when fiscal policy is considered, short-term macroeconomic effects primarily affect the aggregate demand. However, they can also influence the supplied quantity of goods and services. This means that the fiscal policy has an impact on the aggregate supply as well.
The changes in taxes determine the employee’s and producer’s motivation to work and produce goods and services. When the creators of the economic policy decide to lower the taxes, the employees and the producers are left with a bigger percentage of the total earnings. Basically, they earn more money. This motivates them to increase their productivity and thus produce more goods and services for the consumers. In other words, the decrease of tax rates increases the supplied quantity of goods and services at every price level, which shifts the aggregate supply curve to the right.

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In approaching this question, you may want to look at ways aggregate supply is affected in general. Aggregate supply is the goods or services a company is willing to sell at a given time, at a given price point. Aggregate supply can be affected by a variety of factors. These factors include changes in technology, changes in the price of resource items, increase or decrease in production capacity, and– even the company's expectation to be able to sell at a higher price in the future. When we address fiscal policy, we are talking about the use of government spending and taxation. Let’s assume we own an energy drink company. How could our aggregate supply be affected by fiscal policy? Examples could include the government providing tax breaks for the technology we are using, a higher tax mandated on one of our main ingredients, or even government legislation that may limit the sale of energy drinks to young consumers.

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When we talk about how fiscal policy affects the macroeconomy, we are generally thinking about its impact on aggregate demand.  However, fiscal policy can also have an impact on aggregate supply.  The impact on aggregate demand is more direct and it occurs more quickly while the impact on aggregate supply is indirect and tends to happen only over a longer period of time. Let us look at three ways in which fiscal policy can have an impact on aggregate supply.

First, fiscal policy can create more capital.  One aspect of fiscal policy is government spending.  Some government spending goes to things like building roads and other types of transportation facilities.  When the government spends money in this way, it can increase aggregate supply.  It does this because building roads makes it easier to move things from place to place, thus making it easier for businesses to get materials they need and to get their products to their customers.

Second, fiscal policy can impact the amount of work that is done in the economy.  Some economists believe that lowering taxes will create more of an incentive for people to work.  If people can keep more of the money that they make, the theory goes, they will work more hours.  When this happens, aggregate supply will increase.

Finally, fiscal policy can lead to greater innovation.  For example, if taxes on businesses are lowered, they will have more money to put into research and development.  If they use their money in this way, they will tend to develop new products and new techniques.  Doing so will allow them to produce more things, thus increasing aggregate supply.

In these ways, fiscal policy can affect aggregate supply, though the impacts will not be very direct or very immediate.

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We usually say that fiscal policy has more of an impact on aggregate demand (AD) than on aggregate supply (AS).  However, it is possible for fiscal policy to affect AS.  This can happen through tax policy or through government spending.

It is possible for government spending to affect AS.  This happens only if the government spends money on investments.  For example, if the government spends money on research into clean energy, it might eventually increase AS by increasing our clean infrastructure.

However, we would be more likely to argue that taxation can affect AS.  This is why supply side economists argue that we should lower taxes.  Supply siders argue that a decrease in taxes will lead to an increase in such things as investment and work.  They argue that people will be more likely to work more hours and more likely to invest if they are able to keep more of the money that they make.  Thus, a decrease in taxes should lead to an increase in the amount of work and investment being done.  This will lead to an increase in AS.

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