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?

See Rubric below

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

1 - Fiscal policy is the policy of the government which deals with the governments revenue and expenditure. This is different from the mometary policy by fed but has the same effect on the economy.

2 - In the period of recession , the demand in the economy needs to be increased. Thus the money needs to flow more in the economy. This is done by either cutting the tax rates , increasing the expenditure of givernment or by deficit financing which involves the printing of more currency. All these measures increase the money flow and enhance the demand.

3 - In case of expansionary period or inflation , the demand is to be reduced. Thus tax rates are increased and government spending is cut down. This decreases the demand in the economy and divert the inflation.

4 - The effect of both the policies is different. In one policy dealing with recession , efforts are made to enhance the demand and investment. There is reverse case when the economy is in inflationary phase.