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What Is the Role of Fiscal Policy in a Recession?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 21 November 2016
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Fiscal policy is one of the major vehicles through which the government affects or attempts to affect the condition or outcome of the economy. In other words, the government can utilize it to shape or prod an economy to a desired outcome. For this reason, the government applies fiscal policy in a recession to try to reverse the unfavorable trend and to turn the economy around for the better. The government may apply fiscal policy in a recession through an adjustment of its spending habits or through a downward or opposite evaluation of the rate of taxes.

During a recession, the government might decide to engage in fiscal policies in order to bring about a desired change in the level of demand for goods and services. This is important because the main causes of recessions are an unsustainable consumption, the attendant overheating of the economy, and the inevitable hike in the prices of goods and services. One way to think of an economy in a full economic boom is to imagine that it is a balloon stretching to its full capacity. Unless the volume of air within the balloon is maintained at a desirable capacity, it will soon pass its limit and burst. Where this is the case, the main aim of the fiscal policy would be to try and stimulate the economy to a desirable balance between demand and supply as well as to address other macroeconomic factors, such as unemployment.

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The application of fiscal policy in a recession may affect the economy in several ways, depending on the particular unique circumstances surrounding the economy and the factors of the depression. If the depression is such that the manufacturers and producers of goods and services have scaled back their production, leading to layoffs and high unemployment, a decision to apply a fiscal expansion will have a positive effect on the situation. The application of this type of policy means that the government will engage in spending beyond its revenue, stimulating the production of goods and services as well as decreasing the level of unemployment.

Another way in which fiscal policy in a recession can help to restore the balance of trade in an economy following a recession is by reducing the taxes on personal income. Where the government does this, the consumers will have extra income with which to stimulate the economy through an increase in consumption. Also, an increase in employment means that the workers have the income with which they can contribute to the activity on the market, hopefully helping the economy recover from the recession in a more expeditious manner.

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fify
Post 3

@ZipLine-- That's true. In fact, some economists say that fiscal policies are most effective during a recession.

When there is no recession, fiscal policies like government spending may backfire and cause a liquidity trap. This is when people save money instead of spending it. This has a negative effect on the private sector which ends up increasing interest rates.

But during a recession this usually doesn't happen. When the government increases spending during a recession, it effectively increases demand. People don't save their money, they spend it.

ZipLine
Post 2

@fBoyle-- That could be argued either way. But there is no doubt that during times of economic recession, fiscal policies are necessary for the economy to recover. It cannot be done with monetary policies alone.

When there is no recession, the government doesn't need to change fiscal policies. Monetary fiscals are usually enough and those policies are determined by the Federal Reserve, or Central Bank.

But recessions are different in that the situation is so grave that monetary policies are not effective. This is where fiscal policies come in. Without fiscal policy changes, it would not be possible for a country to come out of a recession. Of course it takes a while, but that's okay.

fBoyle
Post 1

Isn't it bad for the government to intervene in the economy? Shouldn't a free market drive itself?

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