Question

Explain the role of fiscal and monetary policy in an economy facing recession. Use appropriate graph to justify your answer

Answer 1

During the recession, current output (Y0) is below the potential level of output (Y1). Government can adopt expansionary fiscal policy or Fed can adopt expansionary monetary policy. Expansionary fiscal policy can raise government spending or reduce tax such that there is rise in disposable income of consumers which will raise aggregate demand in an economy or Expansionary monetary policy can raise money supply in an economy which will raise cash holding of people and raise their willingness to pay for goods and ultimately raise aggregate demand.

As aggregate demand curve shift from demand to new demand, economy reach to its long run equilibrium point where recessionary gap vanish.