Fiscal policy is best visualised with the AD-AS model because it links government actions to economy-wide spending, real GDP, and the price level. Correct diagrams emphasise AD shifts, new short-run equilibrium, and resulting macro outcomes.

Core idea: fiscal policy works through aggregate demand

Fiscal policy changes planned spending in the economy, which changes aggregate demand (AD) in the AD-AS model.

A key diagram rule: fiscal policy is represented as a shift of the AD curve, not a movement along AD. The price level changes only after the new equilibrium is found.

How to show fiscal policy on the AD-AS graph

Set up the initial equilibrium

On a standard AD-AS graph:

• Vertical axis: price level (PL)

• Horizontal axis: real GDP (Y)

• Curves: AD downward sloping, SRAS upward sloping (short run), and sometimes LRAS vertical (potential output)

Start by identifying the initial equilibrium at the intersection of AD and SRAS (and note whether it is left of, on, or right of LRAS if LRAS is shown).

Show expansionary fiscal policy (to increase AD)

Expansionary fiscal policy (higher government spending and/or lower taxes) increases total planned spending, so:

• AD shifts right from $AD_1$ to $AD_2$

• The economy moves to a new short-run equilibrium where AD intersects SRAS

Label the outcomes clearly:

• Real GDP rises ($Y_2 > Y_1$)

• Price level rises ($PL_2 > PL_1$)

This is the classic short-run AD increase: output and the price level move in the same direction.

Show contractionary fiscal policy (to decrease AD)

Contractionary fiscal policy (lower government spending and/or higher taxes) reduces total planned spending, so:

• AD shifts left from $AD_1$ to $AD_2$

• Find the new short-run equilibrium at the new AD–SRAS intersection

Label the outcomes:

• Real GDP falls ($Y_2 < Y_1$)

• Price level falls ($PL_2 < PL_1$)

Again, with AD shifts, real output and the price level move in the same direction in the short run.

Diagramming tips that earn full credit

Always distinguish “shift” vs “movement along”

• Fiscal policy causes a shift in AD

• A change in the price level causes a movement along AD (not fiscal policy)

Use correct directional labels and avoid curve confusion

• Do not shift SRAS for fiscal policy (SRAS shifts are cost/expectations driven)

• Do not shift LRAS for fiscal policy (LRAS changes reflect capacity/potential output)

How to label the new equilibrium cleanly

Include, at minimum:

• Initial equilibrium point (often $E_1$) and new equilibrium point ($E_2$)

• Initial and new price levels ($PL_1$, $PL_2$)

• Initial and new real GDP ($Y_1$, $Y_2$)

• The AD curve shift with an arrow (right for expansionary, left for contractionary)

Interpreting results at different starting positions

If the economy starts below potential output

A rightward AD shift typically:

• Raises real GDP toward potential

• Raises the price level (often modestly if there is slack)

If the economy starts at potential output

A rightward AD shift:

• Raises the price level

• Raises real GDP in the short run (because wages/prices are sticky), even though potential output is unchanged

A leftward AD shift from potential tends to lower both real GDP and the price level in the short run.