Question

(b). Suppose an economy is in recession with historically high unemployment . Using the Keynesian income-expenditure model, explain how an expansionary fiscal policy, involving a reduction in the marginal tax rate can reduce the unemployment rate. What does your explanation suggest about using the overall budget balance as an indicator of the stance of fiscal policy?

Answer 1

Under Keynesian income expenditure model, aggregate demand assumes prominent role. The economic recession emerged as a result of deficiency in aggregate demand. In order to stabilize the economy, fiscal policy used as a tool. When an economy experiencing recession and unemployment, government introduces expansionary fiscal policy to stimulate the economy. The expansionary fiscal policy implies reduction of marginal taxes and increase in government expenditure. The reduction in taxes increases the purchasing power of people's and in order to limit the problems of unemployment, government inject huge amount in the economy. Thus Keynes stood for the adoption of expansionary fiscal policy when economy experiencing recession and use contractionary fiscal policy in boom situations. Under Keynesian income expenditure model, the economy is operating at less than full employment unlike in classical theory.