How Fiscal Policy does affects interest rate and aggregate demand?

Fiscal Policy - refers to the use of government spending and tax policies to influence economic
conditions, including demand for goods and services, employment, inflation, and economic
growth.

- The two main instruments of fiscal policy are government expenditures and taxes.

- Fiscal policy is largely based on ideas from John Maynard Keynes, who argued
governments could stabilize the business cycle and regulate economic output.

Expansionary fiscal policy is defined as an increase in government expenditures and/or a

decrease in taxes that causes the government's budget deficit to increase or its budget surplus
to decrease.

Purpose
The purpose of expansionary fiscal policy is to boost growth to a healthy economic level. This is
needed during the contractionary phase of the business cycle. The government wants to reduce
unemployment, increase consumer demand, and avoid a recession. If a recession has already
occurred, then it seeks to end the recession and prevent a depression.

- The logic behind this approach is that when people pay lower taxes, they have more
money to spend or invest, which fuels higher demand. That demand leads firms to hire
more, decreasing unemployment, and to compete more fiercely for labor. In turn, this
serves to raise wages and provide consumers with more income to spend and invest. It's
a virtuous cycle.

- Rather than lowering taxes, the government may seek economic expansion through
increases in spending. By building more highways, for example, it could increase
employment, pushing up demand and growth.

- Expansionary fiscal policy is usually characterized by deficit spending, when government

expenditures exceed receipts from taxes and other sources. In practice, deficit spending
tends to result from a combination of tax cuts and higher spending.

How It Works
Expansionary fiscal policy puts more money into consumers' hands to give them more
purchasing power. It uses subsidies, transfer payments including welfare programs, and income
tax cuts. It reduces unemployment by contracting public works or hiring new government
workers. All these measures increase demand. That spurs consumer spending, which drives
almost 70 percent of the economy. The other three components of gross domestic product are
government spending, net exports, and business investment.
Contractionary fiscal policy is defined as a decrease in government expenditures and/or an
increase in taxes that causes the government's budget deficit to decrease or its budget surplus
to increase

Purpose
The purpose of contractionary fiscal policy is to slow growth to a healthy economic level. That's
between 2 percent to 3 percent a year. An economy that grows more than 3 percent creates
four negative consequences.

● It creates inflation. That's when prices rise too fast in clothing, food, and other
necessities. Higher prices quickly gobble up savings and destroy the standard of living.
● It drives up prices in investments. That's called an asset bubble. It's happened in stocks,
gold, and oil. An example of its devastating effects is the 2006 housing bubble. By 2005,
the cost of housing became unaffordable for most families. Banks lowered their terms to
entice subprime borrowers, creating a crisis in 2008.
● It's unsustainable. Growth at 4 percent or more leads to a recession. That especially
occurs with asset bubbles. Unfortunately, a recession is part of the business cycle.

How It Works
When governments cut spending or increase taxes, it takes money out of consumers' hands.
That also happens when the government cuts subsidies, transfer payments including welfare
programs, contracts for public works, or the number of government employees. Shrinking the
money supply decreases demand. It gives consumers less purchasing power. That reduces
business profit, forcing companies to cut employment.