Question

Consider the following two independent cases for an economy, which is facing a prolonged recession. In the first case, the government decides to increase its purchases by increasing its expenditure on infrastructure development. How does this increased expenditure affect the economy’s aggregate demand and output level? In the second case, if the central bank of the country increases the interest rate, how does it affect the economy’s aggregate demand schedule and the output?

Answer 1

In the first case government is increasing its expenditure on infrastructure. This is a part of fiscal expansion and it will encourage aggregate spending. Aggregate demand curve shift to the right and this will increase the level of output and the price in the short run. Recession can therefore be eliminated with the help of fiscal expansion

In the second case the central bank is increasing the rate of interest which is likely to reduce the money supply. This will discourage aggregate spending and aggregate demand curve will shift to the left. This decrease the level of output and the price in the short run. Recession can therefore be aggravated with the help of monetary contraction.

Looking at these two cases we see that an appropriate policy to combat recession is the first one where the government is increasing its expenditure and encouraging aggregate demand. The second one is a regressive policy because it makes the reception more complex and prolonged.