Fiscal Policy

Fiscal Policy

The use of fiscal policy shifts the IS curve, thereby affecting the equilibrium income and interest rate. In the case of an expansionary fiscal (when G is increased or T is reduced) for e.g., the IS curve shifts right, resulting in an increase in the equilibrium level of income and interest rate. A contractionary fiscal policy has the opposite effect.

An expansionary fiscal policy causes interest rate to rise (to maintain equilibrium in the money market). The increase in interest rate in turn causes a decline in investment spending. The decline in investment spending will partially offset the increase in aggregate demand resulting from the increase in government spending. Consequently the increase in income less than in the simple Keynesian model which does not take the offsetting effect into account. An expansionary fiscal policy raises interest rate which therefore dampens its expansionary fiscal impact.