The third contributor and also an important key player to aggregate expenditure is the country’s government. Why are there important players in the economy? Governments, especially those who maintain strong political power and authority, can influence the spending of consumers and firms. They, too, can spend! When a government decreases taxes to promote spending by firms and households or pumps money into the economy to stimulate grow, this is called an expansionary fiscal policy.
It is all in the government’s interest to promote economic growth. But there are times where the government has to make the economy contract as well. You see, inflation is a result of economic growth. As you will learn later about the Phillips Curve, there will be a trade off between unemployment and inflation. So as we eliminate unemployment through economic growth, we are bound to experience heightened inflation. But when prices shoot through the roof and the government has to do something about it, contractionary fiscal policy comes into play, where taxes are raised and government spending reduced.
All these about fiscal policies and as well as monetary policy, policies to manipulate the money supply in order to stimulate or reduce growth, will be covered when we talk about the ISLM model.
However, what’s important here is that you see the impact of the government’s policy on aggregate expenditure. And how the AE equation can be manipulated given certain government budget policies.
At the end of this video, you should be able to:
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