Question

Describe the proper fiscal policies required to eliminate recessionary gaps and inflationary gaps.

Answer 1

Expansionary Fiscal Policy required to eliminate recessionary gaps.

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap � meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.

Contractionary Fiscal Policy required to eliminate inflationary gaps.

Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.

fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economic growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.

One thing to remember concerning fiscal policy is that a recession is generally defined as a time period of at least two quarters of consecutive reduction in growth. It may take time to even recognize whether or not there is a recession. With fiscal policy, there will be certain levels of lag time in which conditions will deteriorate before being recognized. At the same time, fiscal policy takes time to implement due to legislative and administrative processes, and those same policies will take time to show results after implementation.

Consumers can also react to these policies positively or negatively. Most consumers would have a positive reaction per say to a policy that lowers taxes, while some will have an issue with a government spending more which will increase the burden of debt on nations citizens.