What would happen if expansionary fiscal policy was implemented in a recession but, due to lag, did not actually take effect until after the economy was back to potential GDP?

Expansionary fiscal policy refers to government measures aimed at increasing aggregate demand, output, and employment in an economy. This is typically done through increasing government spending or cutting taxes, which in turn boosts household and business spending. Expansionary fiscal policy is often used to combat economic slowdowns or recessions.

A recession is a period of negative economic growth that lasts for at least two consecutive quarters. Potential GDP refers to the maximum sustainable level of output that an economy can produce without causing inflationary pressures. It represents the economy's long-term growth trend and is the level of output that corresponds to full employment and stable inflation.

Policy lags refer to the time it takes for fiscal policy measures to be implemented and have an impact on the economy. Government spending can take time to be approved and allocated effectively, while the effects of tax cuts on consumer spending may not be immediately felt. Consequently, the lag in policy implementation can cause delayed effects on economic performance.

If this scenario were to occur, it means that expansionary fiscal policy measures would be increasing aggregate demand beyond the level consistent with potential GDP. The economy would be operating at full capacity, and further increases in demand could lead to demand-pull inflation.

When the policy takes effect, there will be a few major consequences: 1. Inflationary Pressures: The economy will experience inflationary pressures as the increased demand for goods and services pushes up prices. 2. Overheating Economy: As the stimulus measures take effect, the economy may overheat, which can lead to higher levels of inflation and potential future economic instability. 3. Crowding Out Effect: The increased government spending could lead to higher interest rates, which might crowd out private investment. 4. Unsustainable Growth: The boosted output and employment levels could prove to be unsustainable in the long run, potentially setting the stage for a future economic correction or downturn as the fiscal policy measures are eventually scaled back. In conclusion, if expansionary fiscal policy were implemented during a recession but did not actually take effect until the economy had returned to potential GDP, it would likely lead to inflationary pressures, unsustainably high levels of output and employment, and an increased risk of future economic instability. Therefore, it is essential for policymakers to consider potential lags in policy implementation when designing fiscal policies.