Fiscal Policy and Potential GDP

Fiscal policy
Fiscal policy refers to the use of government taxation, spending and borrowing to satisfy macroeconomic goals.

Three major ways that fiscal policy to increase aggregate demand:
Lower business tax - can change the profitability of businesses and the amount of business investment.
Increase government spending
Lower tax for individuals - increase disposable personal income and increase consumption spending.

Fiscal policy has an advantage over monetary policy as increase in government spending leads to an immediate increase in aggregate demand. However, the effects of a tax cut may be more moderate and have more of a time lag because individuals may not immediately spend their increases in disposable income that resulted from the tax cut.

Potential GDP
The GDP resulted from an economy operating at full employment with full utilization of capital is called potential GDP.

Supply-side effect
The effects of the changes in fiscal policy on aggregate supply is called supply-side effect.

Increase in taxes on expenditures and/or income => less labour supplied => supply curve shift up to the left=> reduce aggregate supply of labor, real GDP and potential real GDP.