Question

There is general agreement among economists that if an economy is headed towards a depression, the appropriate fiscal policy:

A) is sound finance.
B) is sound finance, unless the country is also currently at war.
C) is functional finance, and fiscal policy should be contractionary.
D) is functional finance, and fiscal policy should be expansionary.

Answer 1

The correct fiscal policy when an economy is headed towards a depression is functional finance with an expansionary strategy, involving an increase in government spending or a reduction in taxes to stimulate aggregate demand and combat recession.

Step-by-step explanation:

When an economy is headed towards a depression, the consensus among economists is that the appropriate fiscal policy is functional finance, and fiscal policy should be expansionary. Expansionary fiscal policy involves either an increase in government spending or a reduction in taxes to boost aggregate demand. This policy is most effective in a recession, when the economy is producing below its potential Gross Domestic Product (GDP), as it stimulates economic activity and helps to offset the slowdown.

Conversely, contractionary fiscal policy, which involves cutting government spending or increasing taxes, is suitable when an economy is producing above its potential GDP and aims to cool down an overheating economy. However, it’s not recommended during a depression because it would likely exacerbate economic decline. Therefore, the correct response to the student’s question is functional finance with an expansionary fiscal policy approach.