Question

(10 points) If the government decided today that aggregate demand was too low and the economy was experiencing a recessionary gap, how could the government use the tools of fiscal policy to correct this problem? Explain what could be done using each of the three tools. Explain the impact on prices in comparison to the self-correcting mechanism discussed in Chapter 10. (All three methods are the same in this respect.) Think in terms of aggregate supply and demand curves.

Answer 1

Introduction:-

Recessions are part of how the economy grows and develops and creates opportunities and tackles problems that may happen due to internal and external reasons. During a recession, the aggregate demand by people begins to fall this is because they have little or no money left to purchase goods or services being offered in the market place. As a result, the producers have to bare losses which they reduce by reducing the overall costs of production or the total production itself which leads to layovers which further hinders the overall income for the society at large.

The most recent mass recession hit the globe during the housing crisis in the United States which lead to mass scale unemployment across the globe and big problems for the world which called for economic and social reforms.

There are two main ways through which such situations are tackled in the real world. These are through the use of Fiscal Policies which represent government spending and taxation, and Monetary Policy which regulates the flow of money in the economy by the Central Banks by adjusting the interest rates.

For the purpose of answering this question, we only consider Fiscal Policy, its tools and the way in which they are used to alter the prices and demand during a recession.

Case Specifics:-

During a recession, the government of the day, want to do everything possible to increase the demand. It has 3 Primary tools which it uses as part of the Fiscal Policy which helps in increasing the demand and bringing back equilibrium in the markets respectively. This is also known as an expansion fiscal policy

The three tools are as described:-

1) Taxes:-

Taxes represent an important part of how, the fiscal policy is directed towards curbing the effects of recession. People pay Individual Income Taxes, whereas companies are subjected to other rates of taxes which are usually higher when compared.

Taxes are an effective way, in which the governments can tackle aggregate demand and supply. Once the taxes are reduced, the net disposable income which the people are left with increases. This leads to a growth in the overall demand and producers have higher reserves of money which can be used to hire more people and increase the aggregate supply.

Thus, lowering taxes increases the aggregate demand and supply by giving people more money in their hands which allows them to purchase and spend more thus pushing recession to an end respectively.

2) Transfer Payments:-

Transfer Payments are another method in which the government directly adjusts the income of the people thus effecting their buying patterns. For example in the United States, Unemployment Allowance and Social Security represent majority of the transfer payments which reach the end consumers directly from the governments.

If the government increases it’s spending on transfer payments, people directly have more money which can be spent on making purchases with the amount of money at their disposal increasing, they spend more and are able to avert recession respectively.

3) Government Spending:-

Another critical method, in which government alters recession is by increasing government spending. Governments directly purchase goods and services from the private sector. By altering spending and increasing the same, they increase the profits of the private sector while making huge investments in the field of infrastructure and strengthening the economy.

The resultant is that aggregate supply rises and so does the need for employment. This means people now have more income and can purchase more easily, thus increasing aggregate demand also.

Part B)

Recessions may also go away in the long run by market force adjustment of demand and supply. This happens because prices of goods are pushed very low and people start consuming more in the long run. However, often governments have found that this takes a lot of time, and recessions need to be tackled more pro-actively than just waiting for the market forces to naturally change anything.

Please feel free to ask your doubts in the comments section if any.