What is a recessionary gap
How does fiscal policy close a recessionary gap
How does fiscal policy help close a recessionary gap, or how does fiscal policy help take an economy out of a recession? Assume we are in a recession, and have a recessionary / contractionary gap as is shown below In reality think year 2008, and you will get the picture. Then based on diagram 1:
Economic equilibrium is at point A, where the economy is producing at its potential output (PO) level, a real GDP of 15 trillion dollars. This is the equilibrium because it is at the intersection of the long run aggregate supply (LRAS, which is same as the PO level) and the aggregate demand (AD) and aggregate supply (AS) curves. Thus AS = AD = LRAS = PO = 15 trillion dollars. Then we slide into a recession (think year 2008), and the economy is now producing below its PO level, at point B, where real GDP is 14 trillion dollars. Thus we have a contractionary / recessionary gap of 1 trillion dollars. We are producing below our full capacity by that amount. Here the government will use expansionary fiscal policy, which will include a cut in taxes and an increase in government expenditure. How would this help close the contractionary gap and bring the economy out of this recession? The basic idea is to take steps which will increase aggregate demand from AD1 back to
AD. Now as the government reduces taxes, people's disposable income (income after taxes or gross income minus taxes) increases. Since income and consumption are positively correlated, consumption of goods and services across will increase too. This raises the AD1 curve towards AD. As business taxes, capital gains taxes etc. go down, businesses have more money to invest This creates employment, income and higher output. This new income is spent on food, clothing, housing and so on. Thus aggregate demand pushes higher towards AD. Then as government expenditure goes up on say social infrastructure as roads, highways, hydroelectric projects, they generate huge amount of new employment and income. This in turn raises the demand for goods and services and so the AD even further. Moreover the government also purchases huge quantities of raw materials as steel, cement, gasoline etc. for these projects. So the output, and through that the employment and income in those sectors also go up. All of these together generate a positive domino effect to push the AD1 towards AD, and economic equilibrium A, thus helping close the 1 trillion dollar contractionary gap.
Try this yourself: Try closing an expansionary gap using contractionary fiscal policy. It is not difficult. The logic is the reverse of the one above. The diagram is the reverse of the one described above, where AD is above full employment equilibrium. Contractionary fiscal policy has to bring it down.
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