Question

For various reasons, fiscal policy changes automatically when output and employment fluctuate:

Do some online research about our last recession in 2007-2009 (or choose any other recession since the Great Depression) and answer the questions below.

Address the following topics in your analysis in your own words:
A. How did the federal government (President and Congress) respond to the recession?
B. What types of fiscal policy did they use (explain in detail)?
C. Explain why tax revenue changes when the economy goes into a recession.
D. Explain why government spending changes when the economy goes into a recession.
E. If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?
F. How do political party politics impact stabilizing fiscal policy?

Answer 1

A. The Federal government sought to buy bonds during 2007-2009 and circulate money in the economy, increase the level of money supply and the level of government expenditure by printing more money and circulating it in the economy. Cutting the rates of interest so that firms get to borrow money at a cheap rate.

B. They used expansionary fiscal policy as they had to increase the level of money supply and liquidity in the economy. Which would ultimately lead to increase in employment, production and demand in the economy.

C. When the economy goes into recession, firms don't earn as much because demand drops significantly due to increase in unemployment rate, this leads to less profits and less tax revenue for the government as it doesn't earn enough through taxes, because profits of firms and individuals are lower.

D. Government spending changes when the economy goes into a recession because private firms are not able to stimulate the economy as there is limited demand for their goods and services, thus households and firms need extra stimulus which is in the form of tax breaks and government spending which brings back the demand in the economy.

E. It wouldn't be able to spend in a recession as revenue would decline and in order to match revenue with expenditure, it would have to reduce the level of expenditure. That will make recession more severe as there is limited stimulus provided by the government.

F. Political parties have only 4-5 years wherein they rule and then they are due for another election, in order to increase the chances of gaining in the next election as well, the political parties pursue short run measures such as extremely large government expenditure by seeking extortionate amount of debts. This reduces the stability of the fiscal policy.