3.6 Demand management - fiscal policy

The government is increasing spending on public sector wages and school buildings. Government spending (G) is one of the two main instruments of fiscal policy (alongside taxation), and the decision is made by the government/treasury, not a central bank.

Since $AD=C+I+G+(X-M)$, an increase in G directly and immediately raises aggregate demand without requiring any change in private sector behaviour first. This shifts the AD curve to the right.

The economy has a negative output gap and rising unemployment, meaning output is below potential. A rightward shift of AD addresses this by raising real output — this is the hallmark of expansionary fiscal policy.

The correct option states this is expansionary fiscal policy operating through a direct increase in G as a component of AD. No other option correctly identifies both the type of policy and the channel through which it works.

The question asks for the correct description of the policy type and its primary channel of influence on aggregate demand.

The option stating this is contractionary fiscal policy that shifts aggregate supply leftward is incorrect on two counts: a rise in public sector wages as a government spending decision is a demand-side tool, and the policy is clearly expansionary, not contractionary.

The option calling this expansionary monetary policy confuses fiscal and monetary policy. Monetary policy involves interest rates and money supply decisions made by the central bank, not government spending decisions made by the treasury.

The option claiming this is contractionary fiscal policy via crowding out contradicts itself: crowding out is a potential limitation of expansionary policy, not a reason to classify the policy as contractionary. An increase in G cannot be contractionary by definition.

Only the remaining option correctly identifies an increase in G as expansionary fiscal policy working through a direct addition to the AD equation.

A tax rebate works indirectly: it raises household disposable income, and then AD rises only if households spend that extra income. An increase in government spending works directly: G is itself a component of $AD=C+I+G+(X-M)$, so AD rises immediately.

The proportion of extra income actually spent is the marginal propensity to consume (MPC). If MPC = 0.7, then 70 cents of every extra dollar of the rebate raises consumption (and thus AD), while 30 cents is saved and does not enter AD in that round.

If instead the government spent the same amount on infrastructure, the entire sum enters the AD equation as an increase in G, regardless of any saving decisions by households. This makes the direct spending effect more immediate and predictable.

The correct option captures exactly this distinction: the rebate operates through disposable income and consumption, and is therefore subject to the household saving decision in a way that a direct spending increase is not.

The question asks why a tax rebate may stimulate AD by less than an equivalent increase in government spending, even though both are forms of expansionary fiscal policy.

The option claiming tax rebates are monetary policy is factually wrong. Tax changes are a fiscal policy instrument controlled by the government/treasury, not the central bank.

The claim that a tax rebate cannot influence real output under any circumstances is false. Tax cuts raise disposable income, which raises consumption (C), a component of AD — so there is an effect, just an indirect and potentially smaller one.

The claim that tax rebates always raise the price level without raising real output is too absolute and incorrect. Whether the effect is mainly on prices or output depends on the degree of spare capacity in the economy, not on the type of fiscal instrument used.

Only the correct option accurately explains that the saving behaviour of households (captured by the MPC) is the reason a tax cut may produce a smaller AD boost than an equivalent direct spending increase.