In my coursebook it says that in a deflationary fiscal policy governments may reduce government expenditure (such as building hospitals and road constructions) to reduce aggregate demand but I don't see how is this supposed to affect aggregate demand.

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    $\begingroup$ Could you please explain what you think the elements of aggregate demand are? I.e. who are the entities buying the stuff that was produced? $\endgroup$ – Giskard Dec 5 '17 at 13:07

Aggregate demand is the total domestic demand for goods and services in an economy. Cutting government spending could reduce aggregate two ways.

  1. Direct. Government demand is obviously lower, and is a component of domestic demand.
  2. Indirect. The recipients of income from government spending have less money to spend.

It is theoretically possible that other sectors can raise spending to offset those effects. (If taxes were cut at the same time, this is obviously easier. In that case, there can just be a shrinkage of the government’s share of the economy.) There is a large debate about the empirical effects of spendng cuts. However, since the question just asked for a mechanism, that literature is somewhat out of scope.


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