Reference no: EM131515639

An economy is assumed to be operating at its full potential when its aggregate expenditures (total spending) equal its aggregate output (gross domestic product or GDP). At that at point, the economy produces what it needs and consumes what it produces. When the economy is producing at its full potential, everyone who wants to work can find a job since every worker enters the workforce will produce what she will eventually consume with her income. In such, unemployment rates in the economy represent the natural rate (only frictional and structural unemployment exists). When the economy produces what it needs and consumes what it produces, the price level of final goods/services and the price level of inputs (material and labor) will be at the same. In other words, the rate of change in the prices level of goods and services will be equal to the rate of change in income (wages and return to investment).

However, aggregate demand (what the economy consumes) and aggregate supply (what the economy produces) don't operate in a perfect harmony and they usually move at different speeds. For example, when there is an increase in the population size, there will be an increase in aggregate demand (consumption for baby products, schooling, housing, etc.) while the rate of aggregate supply (labor, capital, technology) might remain the same. Remember, it takes several years for a child to enter the labor market to produce what he/she consumes. This change causes a rise in the price level (inflation) since demand outweighs supply. On the other hand, if the price level of major output (fossil fuel for example) rises, it will cause a rise in the price level of final commodities and a decline in the output, which will lead to a reduction in economic activities (recession) and higher unemployment rate.

To ensure the economy continues to operate at its potential GDP (full capacity where all savings are invested in production functions and all those who wish to work can find a job), governments use fiscal policies to make sure aggregate demand and aggregate supply are close to equal to achieve lower unemployment rates, AND to make sure the price level in the economy reflects its income.

Discuss the primary goals of fiscal expansionary policies and fiscal contractionary policies and their effects on unemployment rates, inflation rates, interest rates, private investment, and GDP.

Are there any risks involved in implementing fiscal policies?