Which component is primarily influenced by fiscal policy?

Fiscal policy primarily affects aggregate demand, which encompasses the total spending on goods and services in an economy over a specific period. When the government adjusts its spending levels and tax policies, it directly impacts consumer and business spending. For example, an increase in government spending injects money into the economy, leading to higher overall demand as consumers and businesses respond to the additional economic activity. Conversely, decreasing taxes can increase disposable income for households, prompting greater consumption and investment. This interaction between fiscal policy measures and consumer behavior solidifies the influence of fiscal policy on aggregate demand.

In contrast, aggregate supply is more closely linked to factors such as technological advancements and production capacity rather than government fiscal actions. Inflation rates can be influenced by a range of factors, including monetary policy and external economic conditions, but fiscal policy's primary role is within the realm of aggregate demand. Foreign exchange rates are determined primarily by trade balances, interest rates, and market perceptions, which also are less directly influenced by fiscal policy than aggregate demand is.