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What Is the Relationship between Fiscal Policy and Aggregate Demand?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 25 September 2016
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The connection between fiscal policy and aggregate demand is the fact that fiscal policy is a macroeconomic factor used by governments to influence the level of consumer consumption in an economy. This may be due to an identified need for an increase in consumption or a desire to slow down consumption with a view to cooling down an overheated market. Examples of how fiscal policy and aggregate demand are connected can be seen in the use of taxation, government spending and other governmental policies like export and import duties to influence consumer consumption.

An illustration of the relationship between fiscal policy and aggregate demand is a situation in which the government increases or decreases corporate tax with the aim of encouraging capital investments and expenditure in the economy. For instance, the government might offer tax allowances to certain industries as a means of encouraging more activity and investment in these industries. The tax allowances may include factors like tax reduction, which will also encourage more foreign investment in the country as a result of the favorable tax regime in the area. This type of tax manipulation is important because it can serve as a basis for more investments, an increase in supply, and an increase in aggregate consumer demand for products.

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When a country exports goods, it results in the increase of the aggregate demand for goods originating from that country. This type of demand flows from the outside of the country and is influenced by such factors as taxation and export regulations. If there is a quota in place putting a cap on the amount of certain goods that may be exported in a stated period, this will have a negative effect on the volume of exports and total aggregate demand. The government may encourage exporting goods from the country through the reduction of custom duties and of other trade tariffs and taxes, which will stimulate the economy through an increase in demand for goods originating from that country. Another way in which the government might try to limit the demand for certain goods might be to put a ban on the import or export of the goods for a stated period.

Fiscal policy and aggregate demand are connected by the decision of a government to increase or decrease its spending. A decision to limit the payment of unemployment benefits and other welfare benefits also affect aggregate demand. Any governmental increase or decrease of income taxes has an effect on the total aggregate demand. For example, a decision to increase income taxes will reduce the available disposable income and consequently reduce demand.

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