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How do Fiscal and Monetary Policies Affect Aggregate Demand

How do Fiscal and Monetary Policies Affect Aggregate Demand?

Fiscal and monetary policies are two important economic policies, especially in studying employment and household income. Know how they affect aggregate demand.

The government in every country frames its economic policies each year to alleviate the economy. These economic policies require careful consideration of various factors to derive the optimum results for the economy. The consideration of employment and household income is crucial to studying economic growth. The government’s economic policies can be classified into two- fiscal and monetary policies. The monetary policies are entrusted with the workings of the central bank. The fiscal policies are entrusted with governmental decisions regarding the economy.

The fiscal and monetary policies affect the aggregate demand of an economy. Aggregate demand is the aggregated demand for services and goods complete in their production. Understanding aggregate demand is essential to further elaborate on how it is affected by various policies. Knowing what fiscal and monetary policies are is also necessary.

In the below sections, there will be an explanation of the concept of aggregate demand. Further, there will be an elaboration of the fiscal and monetary policies, specifically for the Indian economy. The effects of these fiscal and monetary policies on aggregate demand will also be elaborated upon.

Aggregate demand 

Aggregate demand is calculated as the aggregated demand for all the produced and finished goods and services per year. It is the total revenue generated after these finished goods and services are consumed at a given time period. Aggregate demand includes all types of goods: capital goods, governmental spending, exports, imports, and consumer goods.

The aggregate demand is determined by factors such as consumer spending and investment, employment and household income, and others. It is a study of macroeconomics, investigates the total demand that exists in the economy per year, and is directly related to the gross domestic product (GDP). It is the total of produced goods and services per year. Aggregate demand is the desire for goods and services. Therefore, if the aggregate demand falls, the GDP falls too.

Aggregate demand is calculated as the sum of spending by consumers, private investments, spending by the government, and exports and imports. The equation for the calculation of aggregate demand is:

AD = C + I + G + Nx

In the equation, 

AD = Aggregate Demand

C = Consumer Spending

I = Private Investment

G = Government Spending

Nx = Net Exports and Imports

The shift in aggregate demand can be affected by factors such as a shift in money supply, a shift in tax rates, and an increase or decrease in the prices of goods and services.

What are fiscal policies?

Fiscal policies are the policies that are framed for using government spending and taxation to stress the economic status of the economy. These policies are significant influencers for aggregate demand, employment rate, inflation, and economic prosperity. These policies bring the government to the front to stabilise the economic conditions of the economy. Fiscal policies ensure no economic recession and that the economy treats all equally.

The fiscal policies of India were initiated to maintain the growth of the economy and stabilise the situation of employment in the country. In addition to this, these policies ensured the government’s involvement in maintaining the balance of payment. Fiscal policies are classified into three types. These are:

  • Contractionary fiscal policy: This includes cutting down on government spending or increasing taxes
  • Expansionary fiscal policy: It is meant to boost the economy in times of economic recession
  • Neutral fiscal policy: It is meant to balance government spending and taxes
  • The main sources for implementing these fiscal policies are government expenditure, tax collection, surplus, and debt managing initiatives.

What are monetary policies?

Monetary policies are the policies initiated by the central bank in a country to stabilise the economy. The prominent role of these policies is to maintain the supply of money used by the government, consumers, and other enterprises. The monetary policies include revision of interest rates and inflation rate, cash lending, nang reserve requirements, and deposits in banks. 

The monetary policies in India are framed by the central bank, which is the Reserve Bank of India (RBI). The RBI is the sole proprietor controlling the money supply across the country and the state banks. It provides opportunities for investments, lending of loans, and cash to the bank. RBI is completely independent in framing monetary policies. No interventions can be made by the government in the working of RBI.

The impact of fiscal and monetary policies on aggregate demand

Fiscal and monetary policies affect aggregate demand. These can be understood with the below pointers.

Fiscal policies influence aggregate demand through government expenditure and taxation. The more the government expenditure, the more would be the aggregate demand. Similarly, if the tax rates are increased, the aggregate demand would decrease 

The shift in fiscal policies will impact employment and household income. This will impact consumer spending and investment, which are components of aggregate demand 

Monetary policies stress an impact on the interest rates and inflation rate. It affects the money supply, which impacts aggregate demand indirectly. For instance, if people have more cash, consumer spending would increase, and thus, the aggregate demand would increase

Monetary and fiscal policies influence the components used for calculating aggregate demand. They might affect private investments, consumer spending, and government spending

These are the effects of fiscal and monetary policies on aggregate demand

Conclusion

The above sections of information show a complete understanding of aggregate demand, fiscal policies, and monetary policies. Aggregate demand is the aggregate demand for goods and services per year. Fiscal policies are the policies framed by the government for the economy. Monetary policies are the policies framed by the central bank. The effects of these two policies on aggregate demand are highlighted too.