Question

During the 2008 crisis, the Eurozone countries applied different strategies to prevent a fall of aggregate demand.

o Provide two examples of fiscal policies in face of an economic crisis and discuss their positive and negative effects on aggregate demand. Use the concepts of “multiplier effect” and “crowding-out effect”

Answer 1

--> Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy.When a country adopts expansionary fiscal policy,it either reduces taxes or Increases spendings.When a country adopts contractionary fiscal policy,it either Increases taxes or reduces spendings.

-->The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand having multiplier effect on the economy. Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

--> Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential gdp. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes.