Let’s recall the basic equation of national income accounting:

The left-hand side of this equation is GDP, the value of all final goods and services produced in the economy. The right-hand side is aggregate spending, total spending on final goods and services produced in the economy. It is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and the value of exports (X) minus the value of imports (IM). It includes all the sources of aggregate demand.

The government directly controls one of the variables on the right-hand side of Equation 13-1: government purchases of goods and services (G). But that’s not the only effect fiscal policy has on aggregate spending in the economy. Through changes in taxes and transfers, it also influences consumer spending (C) and, in some cases, investment spending (I).

To see why the budget affects consumer spending, recall that disposable income, the total income households have available to spend, is equal to the total income they receive from wages, dividends, interest, and rent, minus taxes, plus government transfers. So either an increase in taxes or a reduction in government transfers reduces disposable income. And a fall in disposable income, other things equal, leads to a fall in consumer spending. Conversely, either a decrease in taxes or an increase in government transfers increases disposable income. And a rise in disposable income, other things equal, leads to a rise in consumer spending.

The government’s ability to affect investment spending is a more complex story, which we won’t discuss in detail. The important point is that the government taxes profits, and changes in the rules that determine how much a business owes can increase or reduce the incentive to spend on investment goods.

Because the government itself is one source of spending in the economy, and because taxes and transfers can affect spending by consumers and firms, the government can use changes in taxes or government spending to shift the aggregate demand curve. And as we saw in Chapter 12, there are sometimes good reasons to shift the aggregate demand curve.

In early 2009, as this chapter’s opening story explained, the Obama administration believed it was crucial that the U.S. government act to increase aggregate demand—that is, to move the aggregate demand curve to the right of where it would otherwise be. The 2009 stimulus package was a classic example of fiscal policy: the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy by shifting the aggregate demand curve.