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?

Calculations:

1. If there a $2billion increase in government spending, other things being equal, what would be the resulting change in aggregate demand, and how much of the change would a change in consumption, if the MPC were the following:

1. 1/3?
2. 1/2?
3. 2/3?
4. 3/4?
5. 4/5?

2. The economy is experiencing a $225 million inflationary gap. If the government decided to solve this macroeconomic disequilibrium using a change in taxes, would you recommend an increase or decrease in taxes? If the MPC =0.9, what magnitude of tax change would be appropriate?

3.  The economy is experiencing a recessionary gap of $30 billion. If the MPC=0.75, what government spending stimulus would you recommend to move the economy back to full employment? If the MPC=0.66

Answer 1

Question 1

PART 1

Fiscal policy refers to the policy with respect to government expenditure and taxes.

This policy is used by the government to eliminate the economic fluctuations and to keep economic stability.

PART 2

During recession, economy's real GDP become less than its potential real GDP.

In such scenario, there is need to stimulate the aggregate demand which in result will stimulate production and would bring economy back to its potential level of output.

To stimulate aggregate demand, government use expansionary fiscal policy which includes increase in government expenditure or cut in taxes.

This leads to increase in aggregate demand and which in result boost the aggregate supply and pulls the economy out of recession.

PART 3

During expansionary period, economy;s real GDP exceeds the potential real GDP.

In such scenario, there is need to stifle the aggregate demand which in result will lead to decrease in aggregate production and would bring economy back to its potential level of output.

To shift aggregate demand, government use contractionary fiscal policy which includes decrease in government expenditure or increase in taxes.

This leads to decrease in the aggregate demand which in result would decrease aggregate quantity supplied and bring back the economy to its potential level of real GDP.

PART 4

Yes, both situations results in different impacts on inflation.

During recession, use of expansionary fiscal policy by government leads to increase in the price level and thereby an increase in the inflation.

During expansion, use of contractionary fiscal policy by government leads to decrease in the price level and thereby a decrease in the inflation.