Question

Explain why we expect the government to run deficits during a recession even if there is no new fiscal policy enacted. (Make sure you talk about both the spending reason and the tax reason for this!)

Answer 1

A deficit is a shortfall in a government's income compared with the government's spending. A recession is a business cycle contraction when there is a general decline in the economic activity of a country. In such a situation, consumers and businesses spend less money.

During recession, the government tends to run deficits even if there is no new fiscal policy that is being enacted. This can be understood by considering both : the spending and the revenue component individually.

During recession, the income of the citizens fall due to less economic activity. There is less consumer spending and thus retail sales fall. This affects the production in the economy. So since there is a fall in income of the economy, it also reduces the sales tax collection of the government.

The revenue of the government also falls because there is a lower production and sales of the goods produced by public enterprises.

Looking at the spending side, a lot of people lose their job during recession due to lower economic activity. Thus the government makes a larger amount of transfer payments such as unemployment benefits. Apart from that, the government spending on goods and investment usually doesnt change even at the time of recession.

So since the revenue falls and the spending rises, the deficit falls even if no new fiscal policy has been implemented.