Question

1. As stated in the article, “Economists agree that the United States must continue to rack up debt to prevent a full-blown depression. Otherwise, there won't be much of an economy left to repay the debt once the health crisis is over.”

a) Recessions exact a major toll on individuals, families, firms, and budgets throughout the U.S. A key aspect of proper macroeconomic policymaking is to minimize losses by responding quickly and effectively to downturns through fiscal policy. Explain!

b) There are two alternatives to borrowing: 1) raising taxes to fund the stimulus package; or, 2) do-nothing and wait for the economy to self-correct. Explain why each of those options are flawed.

Answer 1

Question 1 A)

When, there is a situation of recession in any economy, the aggregate demand for goods and services declines sharply. The recent Corona Virus pandemic has caused another example of a typical recession. As the demand for goods and services remains low, the producers start making significant losses over the months. Once this exceeds their thresholds to reduce profits any further, these firms slow down production levels and begin to fire staff. The resultant is that lower income levels exist in the economy and this further increases the recession in the country.

The recession cycle therefore becomes cyclical in nature wherein, decreased spending and aggregate demand leads to reduced profits or losses for firms which in turn becomes an income hazard for the larger working population of a country.

There is one effective method of quick fiscal intervention in which the government through its taxation and spending capability can reverse the effects of the cycle which has been created in the economy. A fiscal policy is a policy which is set in by the government with regards to elements such as taxation and spending levels which can be altered to correct the economy.

In the event of a recession, the government follows an expansionary fiscal policy, aimed with an effort to reduce the impact on the economy. It reduces the tax rates which are charged from people, the resultant of which is that people have additional money to spend in the economy. It also increases its spending which results in free flow of money in the economy and the recession cycle can end.

For example, if the current tax policy is 10% of your income in a year, and this is reduced to 5%, you have an additional 50% amount which was previously given away as tax which can be reinvested into business by its owners or can be used in consumption of more goods and services respectively. Similarly, from the view point of increasing expenses, the government hands out contracts to private players which brings in additional money for them and they can then employ more people and increase spending capacity which helps in correction of the recession.

Question 1 B)

The flawed nature of both these policy decisions up and above borrowing is as described.

1) Raising Taxes: -

When a country chooses to raise taxes, even though the revenue for the government may increase for a short period of time, companies resist from investing in these areas due to lack of profits most of which goes towards payments of taxes. The net result is that companies prefer taking their business elsewhere wherein their profit margins remain higher. As a result of this disinvestment in the economy, the raised tax rates discourage business and the revenue starts to fall sharply in the long run.

Thus, raising of taxes beyond a limit is of no advantage to an economy which is battling recession as it discourages business owners from creating or expanding operations any further.

2) Do Nothing Strategy: -

A do-nothing strategy in this case also fails to relieve the economy of any cyclical pressure. As explained above, recession happens in a wave, wherein reduced demand brings in reduced production and the overall employment situation along with the gross domestic product which is the sum total of all goods and services produced in the country begin falling. All of these variables are interconnected and we need outside support from the government in the form of tax deductions or increased spending or other measures such as interest reductions by the Central Bank to correct the recessionary gap.

Without such intervention the economy will not revive all by itself. This has largely been seen as a trend in all major recessions such as 2008 Housing Crisis or 2020 Corona Virus Crisis. We need intervention to be able to get an economy outside of a cyclical pressure situation respectively.

Please feel free to ask your doubts in the comments section if any.