Question

Provide arguments for and against fighting recession with expansionary fiscal policy. First, explain the meaning of the terms recession and expansionary fiscal policy. Use the model of aggregate demand and aggregate supply to illustrate your answer. Mention the model of national saving and investment and the crowding-out effect of a budget deficit. (Ch 16 notes).

Answer 1

Recessionary fiscal policy occurs when government reduces its spending and raise tax to reduce the otput level in the economy. Expansionary fiscal policy raises government spending and reduces tax to raise output level in the economy.

Expansionary fiscal policy can be adopted to fight recession in two ways:

1) It can lower the tax of producers and reduce their cost of production which induces them to produce more and take economy to its potential level. It will shift short run aggregate supply to its right from SRAS1 to SRAS2 while AD remains same. It will reduce the price level from P to P1 and raise output level from Y0 to Y1 and curb recessionary gap.

2) It can raise aggregate demand by raising government spending in the economy which will shift the AD curve to its right from AD to AD1 while short run aggregate supply remains the same. It will raise price from P0 to P1 and raise output level from Y0 to Y1.

Expansionary fiscal policy will raise the rate of interest in the economy which will reduce the investment level in the economy. Fall in tax rate and rise in government spending will reduce the national saving. Crowding effect of this policy will occur because private investors will reduce their investment because rise in rate of interest will raise their cost of borrowing.