Question

As an expert macroeconomist, you have been hired by the federal government to act as a consultant and aid with a national economic situation. The economy is currently facing a recessionary gap.

1.            The federal government would like you to provide two fiscal policy solutions that would sift the short run aggregate demand curve and bring about a long run equilibrium. Using the economic knowledge from this course, provide the two policy solutions that you would suggest and explain how they would close the recessionary gap.
2.            The Bank of Canada would like you to provide two monetary policy solutions that would sift the short run aggregate demand curve and bring about a long run Equilibrium. Using the economic knowledge from this course provide the two policy solution that you would suggest and explain how they would close the recessionary gap.
3.            Name and describe 2 Negative economic or negative social consequences which may occur as result of the policies Note You may provide 1 negative economic consequence and 1 negative social consequence.

Answer 1

Recessionary gap refers to the situation where the labor available in the economy is not fully employed, the production capacity is not fully utilized. It is a sign of emerging recession. In pure technical terms recession refers to two consecutive quarters of negative growth in GDP of an economy which is attributed by decline in the economic activity.

1) Fiscal policy - When there is a recessionary gap the government can intervene to avert recession by adopting expansionary fiscal policy. Fiscal policy is the policy which deals with taxation and government spending. Expansionary fiscal policy can be attributed to reduction in the tax rates or increase in government spending or both. Both of these measures of increase in  government expenditure and reduction in tax rates will positively contribute in increasing the demand  and help in tackling the recessionary gap in the short run and reaching equilibrium in the long run.

When the government reduces the tax rates the amount of disposable income with the individuals will increase thus improving their purchasing power and thus augmenting demand and consumption which in turn will positively influence the production.

When the government increases its spending through increasing its capital expenditure or current expenditure it results in shifting the shifting of the demand curve to the right - capital expenditure through the allotment of contracts, projects to individuals and corporate entities by the government to undertake various public projects thus enabling in employing the labor and utilizing the production capacity, this can also consequently result in creating meaningful assets in the economy which can improve the future prospects of the economy. The government can also Increase current expenditure through Increasing direct benefit transfers, increasing the wages of government employees, creating more jobs etc. All these measures will increase the purchasing power of the individuals thus augmenting demand. All such expenditure made by the government will have a multiplier effect and a virtuous effect in increasing the demand and supply in the short run and reaching equilibrium in the long run.

2) Monetary policy - Refers to the policy adopted by the Central bank of a country to regulate the supply of money in the economy. Expansionary monetary policy would be adopted by the central bank toshift the demand curve to the righ and reach equlibrium in the long-run. Expansionary monetary policy entails reduction in interest rates. When the interest rate is reduced  the cost of capital is reduced and this stimulates investments and spending by the firm as they can borrow capital at low cost, they will make investments in augmenting their production capacity, spend money in hiring more labor, demand more raw materials etc and this results in the virtuous circle of increased employment, wages, which in turn increases demand as the purchasing power of the labor force will increase due increased employment and wages. Similarly even individuals can make new purchases by borrowing money at low cost thus boosting the demand for products as their purchasing power will increase with increased access to low cost credit.

The central bank can also print more currency or conduct open market operations of purchasing securities in the capital markets thus improving the liquidity in the markets all these activities will  inflate the supply of money in the economy. When the supply of money in the economy increases, the access to money will improve, credit  will be easily available these in turn will aide  stimulating the economy by increasing demand and supply potential.

Both expansionary monetary and fiscal policy will create a virtuous cycle in the economy by stimulating demand. Thus enabling the economy to reach equilibrium in the long run.

3) The negative economic consequence of expansionary monetary policy is that when the supply of money in the economy increases without corresponding increase in the production capacity in the long-run it will result in depreciation in the value of the currency as its supply will exceed its demand.

The negative social consequence of expansionary monetary policy is the benefit of increased supply of money in the economy may not be distributed in an equitable manner and only a certain small portion of the population might enjoy the benefits of it and this will contribute in widening the gap between the have and have-nots.

The negative economic consequence of expansionary fiscal policy is that there are chances that the government might spend money in haste or without proper planning thus incurring expenditure which fails in creating lucrative and sustainable assets which can generate income or positively contribute to the economy in the long run.

The negative social consequence of expansionary fiscal policy fiscal deficit which the federal government will incur due to increased spending and reduced income through tax cuts. The burden of Fiscal deficit is usually born by the future tax payers though they may not always enjoy the benefits of the expansionary fiscal policy which resulted in the deficit.