Question

Use the AD/AS model to show an economy in recession. Explain how fiscal policy can be used to move the economy back to the long run, full employment level. Explain briefly. (1-2 pages)

Answer 1

During the recession, aggregate demand is lower than long run equilibrium output. This gives rise to a short run recessionary gap. Actual price level is lower than expected price level, and actual unemployment rate is higher than natural unemployment rate.

To pull out the economy from recession, government implements expansionary fiscal policy by

1. Increasing government expenditure on goods and services, and/or

2. Decreasing personal income tax (to increase consumption expenditure) and/or

3. Decreasing corporate income tax (to increase business investment).

These policy tools will increase aggregate demand, shifting AD curve rightward and restoring initial long run equilibrium.

In following graph, long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0), with long-run equilibrium price level P0 and real GDP (= potential GDP) Y0. An economy in recession is at point B where aggregate demand lies to the left of LRAS0 at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).