Question

How does Congress and President use fiscal policy to fight a recessionary gap or inflationary gap?

Why the deficits are good in the short run if the economy is in a recession?

What’s the effect of crowding out on aggregate demand?   
What’s the effect of government borrowings on interest rates and investment?

What’s the negative effect of automatic stabilizers?   

Answer 1

1. The fiscal policy is the use of government spending and tax to change the economy. During times of recession the government follows an expansionary fiscal policy which increase the aggregate demand and moves the economy from a recession to recovery and then to prosperity. During inflationary situation a contractionary fiscal policy removes the inflationary pressure and turns the economy at the normal level of sustainable prices.

During times of recessionary gap the aggregate demand falls short of aggregate supply. The fall in aggregate demand reduce the price level and aggregate production. The actual output of the economy falls below the potential which leads to unemployment to increase above the natural level. To fill the gap of recession, the government uses its fiscal measures like reduction in tax and increase in public expenditure. The fall tax increases the net income of the people which is used for consumption. The increased spending by the government increase the income of the people by the creation of additional employment. Thus in both measure the consumption expenditure increase. Again the increased expenditure by the government in the form of the creation of infrastructure which indirectly induce the private investment. Thus an expansionary fiscal policy increase the aggregate demand increase the price level, increase the aggregate production, aggregate employment. The economy gets recovery from recession.

On the opposite, during times of inflationary gap the aggregate demand will be greater than aggregate supply. This will cause unwanted price increase. To cure this situation the government follows a contractionary fiscal policy like increase in tax and reduction in public expenditure. Such a policy reduce the income of the people since the people left with less income to consumption due to high tax payment and lower employment. Thus the aggregate demand decrease and the price level decrease. The fall in price level creates less incentive on the part of private businessmen to produce. The reduction in investment reduces the employment and income and the economy moves from overfull employment to the normal fullemployment.

2. A deficit budget is one where the government spends more than its revenue. The additional revenue is mobilized by borrowing either internally or externally. Such increased expenditure through borrowing increases the productive assets of the economy. This will creates more income and employment in the economy. This is the best way for a recovery from recession in shortrun.

3. The crowding out effect is the negative effect of a deficit financing. The increased public sector spending has the effect of decreasing the private sector spending. The government undertakes deficit spending in order to increase aggregate demand and the level of economic activity. This may not succeed since the increased public spending through borrowing proportionately decreases the level of private spending. The borrowing by the government wipes out all available savings in the economy which in turn increase the rate of interest. The increased rate of interest reduces the net return on investment in private sector which reduces the private sector production, national employment, income and output. Thus the aggregate demand decreases instead of increasing. Thus the increased public spending fails to create additional employment and income but actually it reduces the positive effect of public spending.

4. The government borrowing directly influences the rate of interest. The government borrows by issuing treasury bonds to the public. The increased borrowing increases the rate of interest. The interest rate in the economy increase. With increase in rate of interest the investment in the economy decrease. Sometimes the government finances the budget by printing additional currency which also increases the rate of interest and reduces the investment. The circulation of more currency increases the price level. With the increase in price level people demand more money for transaction increase and the rate of interest increase which reduce the investment.

5. The automatic stabilizers are tax and transfer payments of the economy which defeat the very purpose of government stabilization policies. The automatic stabilizers reduce the upward and downward effects of spending multiplier. For example during recession the government spending increase which increase the income and the amount of tax to be paid by the people. The increased income tax at higher level of income tax brackets reduces the disposable income and aggregate demand. Thus while the government tries to increase aggregate demand the automatic stabilizers reduce the aggregate demand. On the other during times of inflationary gap the government has the decrease the tax rate and the decreased tax rate increase the consumption expenditure. Thus the purpose of government to reduce aggregate demand is defeated by the automatic stabilizers. During times of recession the existing transfer payment reduce the disposable income and aggregate demand and during times of inflation the existing transfer payment increase the level of aggregate demand. Thus unless the government modify its tax rate and transfer payment, the working of automatic stabilizers work in opposite direction and defeat the purpose of stabilization policies.