Question

If there is a recessionary gap in the economy, discretionary fiscal policy would likely involve an action to:

A) Increase government spending
B) Decrease taxes
C) Increase taxes
D) Decrease government spending

Answer 1

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AEo to AE₁. Expansionary fiscal policy seeks to stimulate output and decrease unemployment.

Step-by-step explanation:

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AEo to AE₁. When this shift occurs, the new equilibrium E₁ now occurs at potential GDP.

For example, during a recession, the government may act to increase aggregate demand by lowering taxes so that individuals have more money to spend. Alternatively, the government might increase spending on projects like road building in order to stimulate economic activity.

This is known as expansionary fiscal policy, which seeks to stimulate output and decrease unemployment in times of recession.