I need help with understanding fiscal policy and the concerns on which the US government bases its spending and taxation decisions. Also why dosen't an increase in aggreate demand translate into an increase in real GDP?
The government bases its spending decisions primarily on the need for government programs. There are an infinite number of ways the government can be of service, though, and so it must choose some programs over others. The limitations imposed on spending arise from conservative voices who decry ever increasing government expenditures. The limitations do not come so much from fiscal restraint; the huge federal debt attest to the fact that the US can spend a lot more than it takes in without any great consequence (at least so far).
From an economic point of view, however, fiscal policy is seen as a way to regulate the economy (although this isn't the thought in the minds of most politicians when they're voting on various projects). Budget deficits were first proposed as a method of stabilizing the economy by Keynes. Because of the multiplier effect, government spending can bring the economy out of a recession or depression. Fiscal policy affects output directly though increasing consumption and government spending and indirectly through the tax and government spending multipliers. It also has an effect on the balance of trade.
Consider the equation
S + T + M = I + G + X
where the leakages in the economy are savings (S), taxes (T), and imports (M). ...
Limitations of fiscal policy, government spending and taxation decisions