Chapter 17: Problem 15

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?

Short Answer

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If expansionary fiscal policy is implemented in a recession but only takes effect after the economy has returned to its potential GDP due to lags, the consequences may be undesirable. The policy would further increase aggregate demand, pushing the economy beyond its potential level, leading to inflation. Inflation erodes the purchasing power of money, redistributes income and wealth, and can create additional economic issues. Therefore, it is essential for policymakers to consider the timing and intensity of fiscal policies to achieve desired objectives without causing unintended problems.

Step by step solution

1. Understanding Expansionary Fiscal Policy

Expansionary fiscal policy refers to the government's use of spending and tax policies to increase the level of aggregate demand in the economy, thus encouraging economic growth. This policy typically involves increased government spending, tax cuts, or a combination of both.

2. Economic Recession and Potential GDP

A recession is a period of declining economic activity characterized by reduced output, employment, and income levels. Potential GDP refers to the maximum output an economy can produce without causing excessive inflation, considering available resources and technology. When the economy is in a recession, it is operating below its potential GDP.

3. Effects of Expansionary Fiscal Policy During Recession

When the economy is in a recession, implementing expansionary fiscal policy can be beneficial as it helps to increase aggregate demand, which encourages investment and consumption. As a result, output and employment levels improve, pushing the economy toward potential GDP.

4. Lag in Fiscal Policy Implementation

Lags refer to the time it takes for fiscal policy to be implemented and for its effects to materialize. There are two main types of lags - recognition lag (time taken to identify an economic issue) and implementation lag (time taken to put the necessary policies in place). In this exercise, we are considering a situation where the expansionary fiscal policy takes effect after the economy has returned to its potential GDP due to lags.

5. Effects of Expansionary Fiscal Policy Implemented Late

If expansionary fiscal policy is implemented in a recession but only takes effect after the economy has returned to its potential GDP, the consequences may be undesirable. The additional increase in aggregate demand caused by the policy will push the economy beyond its potential level, causing inflation. Inflation erodes the purchasing power of money and leads to a redistribution of income and wealth, among other issues.

6. Conclusion

Implementing expansionary fiscal policy during a recession is generally beneficial since it helps the economy recover by increasing aggregate demand. However, if there is a lag in its implementation and the policy only starts showing its effects when the economy is already at potential GDP, it can contribute to inflationary pressures and create further economic issues. Therefore, it is crucial for policymakers to carefully consider the timing and intensity of fiscal policies to achieve the desired objectives without causing unintended problems.

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