Final answer:
The government uses fiscal policy, such as changes in government spending and taxes, to shift the Aggregate Demand curve, which can lead to a higher output, changes in price levels, and potential changes in employment. Other tools like monetary policy also influence AD, causing shifts that affect the overall economy.
Step-by-step explanation:
When the government employs fiscal policy to shift the demand curve, it is directly affecting the Aggregate Demand (AD) curve at different price levels. Government spending on ordinary business such as national defense, social security, and healthcare, as well as tax changes, are examples of fiscal policy tools that impact AD. For instance, a government tax cut can lead to an increase in AD by raising consumption and investment demand, which shifts the AD curve to the right.
If the government increases spending or decreases taxes, this typically boosts AD. Consequently, the new equilibrium point may indicate a higher level of output as well as a possible increase in the price level. Moreover, if the output level increases, firms may need to hire more workers, leading to a decrease in unemployment. However, the effect on the aggregate supply (AS) curve is uncertain - if AD increases more or less than AS, this may lead to inflation or underutilization of resources respectively.
Other policy tools such as monetary policy, which includes changes in interest rates and credit availability by the Federal Reserve, can also affect the AD curve. Higher interest rates discourage borrowing, reducing consumption and investment spending, which shifts AD to the left. Conversely, lower interest rates stimulate consumption and investment spending, shifting AD to the right. These shifts can have a significant impact on output, price levels, and employment in the economy.