Question

Governments to get the economy out of recession or cool the economy down when the economy is overheating often use fiscal policy.  

1. What is fiscal policy?  

2. How can it be used to get the economy out of recession?

3. How can it be used to get the economy out of the situation where the economy is in an expansionary period where we exceed long run potential?  

4. Do both situations result on different impacts on inflation? Why or why not?

Answer 1

1. The fiscal policy is the policy of the goevrnment and it has three tools and that are taxation, public expenditure and borrowing. Through using this tool the government can stabilize the economy when there is disequilibrium in the economy.

2. The recession is characterised by low economic growth, there will be low aggregate demand and deflation. So here the government can improve the siuation by rising the aggregate demand in the economy. It can be done by either by increasing the public expenditure or reducing the taxation. When the government increases the public spending the people should have more money in hands so it will lead to increase in the spending and rise in the aggreagte demand. On the other hand if the government lowers tax rate this leads to an increase in the disposable income and this also leads to more consumption in the economy and rise in demand.

3. When the overtakes the potential gdp, we faces an inflationary gap. So inorder to control this situation the government can either cut the public spending or increase taxation in the economy. This type of policy is known as contractionary fiscal policy.

4. YES, when there is recession the price level is low and the when there is an inflationary gap the price level is high. In a recession there is deflationary situation because the people postpone their consumption to futute, the people expect to fall the price level further.

In an inflationary gap situation there is excess demand so the prices will obviously go up.