Deflation, Fiscal Policy & Aggregate Demand Impacts

Posted on Apr 7, 2025 in Economy

Understanding Deflation and Saving

Deflation is a persistent fall in the average price level within an economy, representing a negative rate of inflation (where the price level, P, falls).

Saving is defined as income that is not spent; it is present consumption forgone. Saving acts as a withdrawal from the circular flow of income, often involving money stored in financial institutions.

Recession, Aggregate Demand, and Unemployment

During an economic recession, there is typically a reduction in Aggregate Demand (AD). When AD decreases (e.g., shifting from AD1 to AD2), real Gross Domestic Product (GDP) also decreases (e.g., from Y1 to Y2). Since the production of goods and services decreases, firms require less labour, leading to cyclical unemployment.

Fiscal Policy Explained

Fiscal policy refers to the government’s adjustment of taxation levels and its own expenditure to influence Aggregate Demand (AD) and achieve macroeconomic objectives, such as reducing unemployment.

Fiscal Policy Tools and AD Impact

Governments can use expansionary fiscal policy to combat recession and unemployment:

  • Cut income tax: This increases households’ disposable income, potentially leading to increased consumption spending (C).
  • Cut corporation tax: This increases firms’ retained profits, potentially providing a higher incentive for them to increase investment (I).
  • Increase government expenditure: Direct spending on infrastructure, services, or other projects (G) boosts demand.

Since Consumption (C), Investment (I), and Government Spending (G) are all components of Aggregate Demand (AD = C + I + G + Net Exports), an increase in these components shifts the AD curve to the right. (Diagram illustrating AD shift required for full explanation). This increase in AD leads to higher real GDP, successfully boosting the economy and creating more job opportunities.

Fiscal Policy Effectiveness and Limitations

The effectiveness of fiscal policy can vary and faces several challenges:

  • Time Lags: There can be significant delays. For instance, it takes time for stimulus packages to be legislated and approved. Furthermore, it takes time for households and firms to react to changes like tax cuts. Effects planned for one period might not materialize until much later (e.g., a policy implemented in late 2009 might only show effects in 2010).
  • Potential Disadvantages:
    • Expansionary policies can sometimes increase income inequality.
    • Significant increases in AD can lead to inflationary pressure if the economy nears full capacity.
  • Factors Influencing Effectiveness:
    • Size of Measures: The magnitude of tax cuts or spending increases matters. A small stimulus package (e.g., only 2% of GDP, as mentioned for Germany) might be insufficient to significantly boost a large economy.
    • Confidence Levels: Consumer and business confidence plays a crucial role. During recessions, even with tax cuts or available funds, households may be reluctant to spend, and businesses hesitant to invest or hire if they lack confidence in the future economy. This reduces the policy’s effectiveness.
    • Short-Run vs. Long-Run: Due to low confidence, fiscal policy might be less effective in the short run (SR). However, it may work better in the long run (LR) as people observe the government’s commitment and potentially see initial positive effects, becoming more likely to spend and invest.

Budget Balance and Aggregate Demand

A government’s budget position relates to its spending (G) and tax revenue (T).

  • Budget Surplus: Government spending is less than tax revenue (G < T).
  • Budget Deficit: Government spending is greater than tax revenue (G > T).

If a government shifts from aiming for a budget surplus to running a budget deficit, it implies either an increase in government spending (G) or a reduction in tax revenue (T), or both. Both actions are components of expansionary fiscal policy and lead to an increase in Aggregate Demand (AD). (Diagram illustrating AD increase required).

The Crowding Out Effect

Explain why the crowding out effect may arise when the government increases its spending. [10]

The crowding out effect can occur when increased government spending (G) is financed by borrowing rather than taxation. Here’s the mechanism:

  1. Increased Government Spending (G): G is a component of AD. An increase in G directly increases AD (e.g., from AD1 to AD2).
  2. Financing the Spending: If the government doesn’t have sufficient funds (e.g., through taxes), it must borrow from the money market (by selling bonds).
  3. Increased Demand for Loanable Funds: Government borrowing increases the demand for loanable funds (or money demand, MD, depending on the model used) in the market (e.g., MD shifts from MD1 to MD2).
  4. Higher Interest Rates: This increased demand for funds drives up the equilibrium interest rate (R) (e.g., from i1 to i2).
  5. Reduced Private Sector Activity: Higher interest rates increase the cost of borrowing for private households and firms. This can deter private consumption (C) financed by borrowing and, more significantly, private investment (I).
  6. Partial Offset of AD Increase: The reduction in C and I counteracts the initial increase in G, causing AD to decrease slightly from its peak (e.g., from AD2 back down to AD3).

Essentially, increased public sector borrowing and spending ‘crowds out’ private sector borrowing and spending by raising interest rates. The overall increase in AD is therefore smaller than the initial increase in G might suggest.