Question

Suppose the economy begins in a recession due to some negative AD shock.

a. Briefly describe the levels of price and output when the economy is in recession.

b.      Suppose the government does not want the economy to stay in a recession, so they increase government transfers. Explain what a government transfer is and give a specific example.

c.      What income-level of households should the transfers target in order to generate the largest possible effect on the economy? Explain.

Answer 1

a) In recessionary gap, output produced is less than full employment level. In the below diagram, Ql is full employment level of production while Qs is current production where Ql - Qs is recessionary gap. Price at this gap is below than the equilibrium point.

b) Suppose the government raise its spending through transfer payments to curb recessionary gap, they will shift aggregate demand curve to its right. As demand curve shifts to its right from demand to new demand, aggregate demand will rise to its potential level where price will rise to P1.

Government transfer is benefit in kind payments such as subsidy given to individuals to consume goods. As government is giving subsidies to consume goods by consumers to raise circulation of money during COVID 19 is example of transfer payment.

c) People below poverty line and lower middle class should be targeted because they are the one who raise their goods consumed when they are given transfer payments because rich people have no imapct on their consumption behavior due to transfer payments.