Question

What would happen if contractionary fiscal policy were implemented during an economic boom but, due to lag,

it did not take effect until the economy slipped into recession?

Short answer

The inner lag impact of fiscal policy is greater than that of monetary policy. During a recession, fiscal policy is effective. It serves to boost overall demand in the economy and create a favourable investment climate.

However, if the economy has already reached its full capacity, expansionary fiscal policy will be ineffective in expanding output.

Step-by-step solution

Step 1. Concept of fiscal policy.

The employment of government spending and taxation to impact the economy is known as fiscal policy. Fiscal policy is often used by governments to foster strong, long-term growth and poverty reduction.

Step 2. Explanation

The inner lag impact of fiscal policy is greater than that of monetary policy. During a recession, fiscal policy is effective. It serves to boost overall demand in the economy and create a favourable investment climate.

However, if the economy has already reached its full capacity, expansionary fiscal policy will be ineffective in expanding output. As a result, inflationary pressures will result from expansionary fiscal policy.

As a result, this is one of the key disadvantages of fiscal policy, which makes it less acceptable at times.