Question

Fiscal policy can be very difficult to employ effectively. Discuss the issues: If in a recession, should the gov't expand spending? What are the pros and cons? Discuss tax policy as well. Could the gov't choose to use monetary policy instead?

Answer 1

During the recession, the aggregate demand is low, thus the unemployment rate is high. The government follow the expansionary fiscal policy after the recession hits the economy. There is a rise in expenditure and a fall in taxes. The rise in government expenditure gives rise to the fiscal deficit. It will increase the high-interest economy and there would be a fall in the private investment. thus, it creates a crowding-out effect.

Pros:

• There is a rise in the expenditure and demand drives up.
• The unemployments level decreases.

Cons:

• There might be inflationary pressure if there is incorrect implementation of policies.
• Crowding out effect might make the fiscal policy less effective.

Ricardian equivalence says that fall in the tax would not help drive up the demand since people are forward looking , thus they reduce their demand expecting rise in the future taxes.

Monetary policy is not as effective as fiscal policy. Outside lag is higher in the monetary policy.