Question

The economy of Palestine is suffering from recession, use the suitable economic policy to correct this situation.

Explain briefly & Graph your answer using Ad & AS model.

Answer 1

Given that the economy of Palestine is suffering from the recession.

The suitable economic policy to correct this situation would be to adopt an expansionary fiscal policy.

Expansionary fiscal policy increases the level of aggregate demand, through either increase in government spending or reductions in taxes. The expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services.

The aggregate demand/aggregate supply model is useful in explaining the appropriateness of the expansionary fiscal policy to help Palestine to come out of recession.

Consider first the situation in Figure 2, which is similar to the Palestine economy during the recession.

The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. At the equilibrium (E0), a recession occurs and unemployment rises.

In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

Thus, with expansionary fiscal policy, the economy of Palestine could be brought out of recession.