5.2.7—Fiscal policy in AD/AS

A change in government spending, taxation or transfers can shift aggregate demand. The final effect on real output and prices depends on the marginal propensity to consume, spare capacity, imports and the response of interest rates and supply.

The multiplier is larger when extra income creates repeated domestic spending and smaller when saving, taxation and imports leak out. Public investment may also shift long-run aggregate supply after a delay.

A road-building programme raises demand for construction inputs; workers’ extra income can support further spending, but imported materials and saving reduce the domestic multiplier.

The initial spending change is not the final GDP change, and fiscal expansion near capacity is more inflationary than expansion with substantial spare resources.