How to Evaluate - Fiscal Policy

(a) Explain fiscal policy and how the government can use this policy during a recession or deflationary period. (10 marks) (b) Using real-world examples, evaluate the extent to which expansionary fiscal policy can be an effective tool to use during a recession. (15 marks)

Part a had this answer:

"Fiscal policy consists of government spending (G) and taxes(T), including both personal income and business taxes. Fiscal policy can be used by governments to influence economic activity by expanding aggregate demand (AD) or contracting AD. Expansionary fiscal policy consists of increasing G, an injection into the circular flow, and/or decreasing T, as taxes are a withdrawal from the circular flow, to boost AD.

In a recession, a government would want to use expansionary policy to increase AD in an effort to increase real GDP or output. AD is made up of four components: consumption (C),investment (I), government spending (G) and net exports (X −M). In other words, AD = C + G + I + (X − M). Whenever consumer expenditure (C), business spending (I), government spending (G) and exports spending (X) increase, or import (M)spending decreases , AD increases and the AD curve shifts to the right.

The diagram below shows downward sloping AD curves and a Keynesian long run aggregate supply curve (AS). The diagram illustrates a recessionary gap. When the AS curve is vertical, RGDP is at full employment (Yfe). However, on AD1, the equilibrium level of Real GDP is below Yfe at Y1. The difference between Y1 (equilibrium) and Yfe (full employment) is known as a deflationary gap. AD is not strong enough to take Real GDP to the full employment level. Expansionary fiscal policy can be used directly to increase economic activity, or real GDP, by increasing G and/or indirectly by decreasing T, which increases consumption C and/or investment (I). This shifts the AD1 curve to the right, signifying an increase in AD at all price levels, as illustrated in the diagram by the shift of AD1 to AD2, bringing the economy closer to Yfe and reducing recessionary effects such as unemployment.

Recessions are often caused by ‘shocks’ to the economy, such as happened in 2008/2009 with the banking crisis and, more recently, the Coronavirus pandemic in 2020. The Coronavirus pandemic was so severe that it caused most economies in the world to drop into recession.