Question

Suppose a developed nation’s economy is showing early signs of a recession. This comes despite fiscal policymakers having implemented a significant tax cut (i.e., expansionary fiscal policy) one year earlier. Since this expansionary policy was implemented, inflation has been rising so the central bank has been taking steps to reduce it back to its pre-fiscal policy level (but not lower). Using the language of the AD/AS model, identify 2 possible causes for the recession, given the facts described above and explain how they might cause a recession.

Answer 1

a recession is a situation where there is a slow down of economic activities for consequitively two periods or we can say there is sign of negative growth for this periods. this happens for various reasons like, consumer confidence, lequidity trap, instability in world market etc. using the AD/AS model we can explain it as follows-

1) there are possibility that the economy is in a full employment level where the AS curve is vertical because government is already applying expansionary fiscal policy and it is cutting tax to encourage effective demand but still as there will be no further increase in output the taxcut will only create inflation and not be able to increase the production and invertment.

2) another reason for the recession could be stagflation that is high infltion and high unemployment . as the government is taking expansionary fiscal policy the inflation has increased and as there is already a slowdown in the market activities the investors are reducing employment rather than increasing it which is ultimately making the economy even slower. in this case aggregate supply is more than aggregate demand still people are not demanding due to unemployment and less income which is a sign of recession.