Fiscal policy measures used for achieving full-employment level of output and price include increase in the government expenditure and cut in tax rates. A cut in tax rates eliminates only the adverse effect of high tax rates, whereas an increase in government expenditure is expected under normal conditions, to generate additional employment. We will therefore explain here the employment and output effect of increase in the government expenditure.
Suppose the initial AD and AS curves are given as AD and AS intersecting at point E1 in fig. . Here equilibrium level of output and process are given by Y1 and P1 respectively. Suppose also that point F is the hypothetical point of full-employment equilibrium with Y3 and prices p3. Since pointF, unemployment. Let the government decide to increase its expenditure to achieve full employment and the maximum potential level of output, while processes are constant. With this purpose the government must increase its spending so that curve AD shifts to AD which passes through point F in panel (b). This requires that the government increases its spending by an amount that makes the IS curve shift from IS to Is in panel (a). The curve IS intersects the LM (P) curve at point F the point of full employment. With the shift in the IS curve to IS, AD curve will shift to AD3 and income level will increase to Y3 and the interest rate will rise to i2, this will happen only when prices remain constant at P1. Prices remaining constant the point of general equilibrium shifts from E1 to F, the point of full employment in panel (b).
However, since prices do not remain constant the equilibrium point F is not stable. The reason in that increase in the government expenditure creates a chain of actions and reactions between the real wage, prices real cash balances, output and employment which make these variables finally settle at a less-than full employment level of output.
The process of transition from point E1 to a new point of equilibrium can be explained as follows. The government expenditure causes the shift in the IS curve from IS1 to IS2 in panel (a). As a result, AD curve shifts from AD1 to AD3 and the equilibrium shift from point E1 to point F in panel(b). Prices go up to P3 and output to Y3. Bue to an increase in the price level, money bolting in real terms goes done as a result, the LM curve shifts leftward from LM (P1) to LM (P2) in panel(a). the curve LM(P2) intersects IS2 at point F2 causing the interest rate to go up to I3 bue to rise in the interest rates, the investment decrease due to the crowding-out effect and hence income falls to a lower level, Y2 therefore, the curve AD3 shifts backward to AD2 showing a fall in output to Y2. Note that at output Y2 and interest rate i1 both product and money markets are simultaneously in equilibrium at point E2 in panel (a). Corresponding to the equilibrium point E2 in panel (a), aggregate demand equals aggregate supply at output Y2 and prices P2. As revealed by point E2 in panel (b). The economy therefore settles at a less than full employment level of output and prices. It may thus be concluded that the government expenditure does not work to its full potentials under variable process. The variable price dampens the result of the fiscal policy. The previous analysis shows that fiscal policy is not fully efficient in achieving the target employment.