Question

How are the 3 tools of fiscal policy used to combat a contradictory gap?

The 3 tools are taxes, gov spending and gov transfers.

Answer 1

The fiscal policy is the use of government spending, taxes and transfer payments to stabilize the economy. This policy may be expansionary or contractionary depending on the economic situations of the economy.

To combat a recessionary output gap the government follows an expansionary fiscal policy under which the government increase the expenditure, reduce taxes and increase transfer payments.

1. Government expenditure.

During times of recessionary gap the government increases its expenditure. The government increases its spending in certain specific sectors which requires a boost. This increased spending not only increases the income of the citizens but also induce the private spending. The aggregate demand increases which in turn raise the price level. The increased price level gives more profit to the firms and the aggregate output expands and the negative output gap will be closed.

2. Taxes.

During times of recessionary situation the government use tax reduction to stimulate economic growth. As the tax rates were lowered people will have more income to spend and invest. The increased income and spending raise the aggregate demand. The increased aggregate demand will increase production by generating more output and employment and spur the economic growth.

3. Increased transfer payments.

During times of recession, the government increases its expenditure on its social security measures such as old age pension, disability pension, and unemployment compensation etc. Such measures increase the level of income and more consumption, more production and more growth which is necessary to remove a negative output gap.