Question

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is: a. The worst possible combination of tax and expenditure changes. b. The best possible combination of tax and expenditure changes. c. A mediocre and contradictory combination of tax and expenditure changes. d. None of the above.

Short answer

c. A mediocre and contradictory combination of tax and expenditure changes.

Step-by-step solution

Understanding Aggregate Demand

Aggregate demand represents the total demand for goods and services in an economy at a given overall price level and in a given time period. During a recession, aggregate demand is typically low, leading to reduced economic activity and increased unemployment.

Examining Government Spending

Increasing government spending is a fiscal policy tool used to stimulate the economy. When the government spends more, it can increase aggregate demand by providing more public goods and services, which can lead to increased employment and income.

Analyzing the Effect of Raising Taxes

Raising taxes generally reduces consumers' disposable income, leading to decreased consumption. This can counteract the effects of increased government spending by reducing aggregate demand.

Assessing the Combined Policy Suggestion

Combining higher government spending with higher taxes can create a contradictory fiscal policy. While increased spending aims to boost demand, raising taxes may negate these effects by reducing consumer and business spending capacity. Thus, it can be seen as a counterproductive or "mediocre" combination since the policies work against each other.

Choosing the Best Answer

Based on the analysis, option (c) fits best. Increasing government expenditures aims to stimulate demand, but concurrently raising taxes suppresses demand, making this a mediocre and contradictory fiscal policy combination.

Key concepts

Aggregate Demand

Aggregate demand is the total quantity of goods and services desired in an economy at a specific time and price level. It consists of consumer spending, investments, government spending, and net exports. During a recession, aggregate demand typically falls. This is because people and businesses are less confident about the economy, leading them to reduce spending.

• Consumer Spending: This is often the biggest part of aggregate demand. If consumers feel nervous about the economy, they spend less.
• Investment: Businesses might delay or reduce their investments in new projects or equipment if they expect slow sales.
• Government Spending: This is the component that can be directly manipulated by policy to stimulate demand.

A decrease in aggregate demand can lead to higher unemployment and less production. This is why policymakers are so focused on finding ways to boost it during recessions. If aggregate demand is strong, the economy tends to be healthy.

Government Spending

Government spending is a powerful tool in fiscal policy to influence the economy. By increasing spending, the government can raise overall demand for goods and services. This is done by funding public projects and services such as infrastructure, education, and healthcare.

• This spending injects money into the economy, creating jobs and increasing incomes.
• With more people employed, consumer spending can potentially increase.
• This, in turn, can boost production as businesses respond to increased demand.

However, this boost needs to be carefully managed because government debt could increase if spending is not aligned with revenue. During a recession, increased government spending is often seen as essential to kick-start economic growth and reverse economic decline.

Taxes

Taxes are used by governments to collect revenue for public services and goods. Raising taxes can have a dampening effect on the economy since it reduces the amount of disposable income that people and businesses have.

• With less disposable income, consumers might spend less on goods and services.
• Businesses, with less profit, might reduce their investment spending.
• This reduction in spending can lead to a decrease in aggregate demand.

A rise in taxes during a recession can be particularly counterproductive because it might reduce consumption even more, making it difficult for an economy to recover. Therefore, it is crucial to strategically balance tax policies to avoid hampering economic growth while still generating necessary government revenue.

Recession

A recession is a period when an economy experiences a decline in activity. Typically characterized by decreased GDP, high unemployment, and reduced consumer spending, it occurs when economic output falls for an extended duration.

• The decline in spending and investment during a recession causes businesses to cut back, leading to job losses.
• High unemployment leads to reduced disposable income, further reducing aggregate demand.
• To combat a recession, governments often implement fiscal policies to boost demand.

These fiscal policies can include lowering taxes and increasing government spending to put more money into people's pockets, encouraging them to spend more. Thus, understanding the dynamics of a recession helps policymakers decide on effective measures to stimulate the economy and prevent extended economic hardship.