Question

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand and raising taxes simultaneously to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is

1. the worst possible combination of tax and expenditure changes.

2. the best possible combination of tax and expenditure changes.

3. a mediocre and contradictory combination of tax and expenditure changes.

Short answer

Option (c): a mediocre and contradictory combination of tax and expenditure changes.

Step-by-step solution

Meaning and cure of recession

A recession is a phase of the business cycle when the economic activities slow down, and the real domestic output falls below the potential level.In such a situation, the total spending is not able to match the potential GDP.

Thus, a shortage of total spending reduces consumer demand and increases unemployment, further reducing the economy’s output. A recession can be cured by injecting the economy’s total expenditures. It will further stimulate consumer demand and production, increasing economic growth

Explanation for the answer

An increase in spending will expand the aggregate expenditure, thus stimulating the aggregate demand.Higher demand will pull the prices up, and production will increase while recession will be weakened.

An appraisal in taxes will contract the disposable income of consumers, thus contracting private consumption and the economy’s aggregate expenditure.A contraction in aggregate expenditure will reduce the aggregate demand, leading to a fall in prices and output.

Thus, increasing spending and raising taxes simultaneously will neutralize each other’s effect. Therefore, it is a mediocre combination. Also, it is a contradictory combination of tax and expenditure changes because both produce opposite results.