Question

a)Suppose the economy is hit with a negative aggregate demand shock that pushes the country into a recession where the economy is producing less than potential output. How would automatic stabilizers affect the severity of the downturn compared to an economy without automatic stabilizers? Explain your answer.

b)Name three examples of discretionary fiscal policy that could be used to combat the recession. Draw a graph to illustrate the effects of these policies in the AD‐AS model. If AD shifts, explain what component is affected and why. If SRAS shifts, explain why.

c)How will these policy actions affect output, prices, and unemployment?

Answer 1

The automatic stabilizers work to stabilize the economy without any fiscal policy taken by the government. It can work in either of the two ways:

• In time of recession the unemployment rate in the economy goes up. Hence the income of the people decreases. The government receives lower tax revenues. This reduces the tax burden to the people and help to reduce the severity of recession.
• In time of recession the unemployment compensation of the government also raised high as number of unemployed increases. This increases the government expenditure and help to increase the aggregate demand.

As the automatic stabilizers responds to the business cycle and without any action by the government this responses with the change in business cycle. The fiscal policy actions are political process and hence content lag between recognition and implementation of a fiscal policy is subject to time lag. On the other hand as automatic stabilizers act with the business cycles there is no appreciable lag between recognition and implementation of the policy.