Final answer:
A tax cut and an increase in government spending both help in leading an economy out of recession by shifting the aggregate demand curve to the right. Tax cuts have a varying impact based on the marginal propensity to consume, while government spending usually has a larger multiplier effect because it's fully injected into the economy.
Step-by-step explanation:
When an economy is in recession, the government can respond by either cutting taxes or increasing government spending (GDP-G) to stimulate economic activity. Tax cuts enhance consumer and investment spending which shifts the aggregate demand (AD) curve to the right. This increase in AD leads to higher real GDP and lower unemployment, thus helping the economy recover. On the other hand, an increase in government spending directly boosts aggregate expenditure, bringing the economy closer to full employment.
The efficacy of either approach can be better understood through the concept of multipliers. The tax multiplier effects depend on the marginal propensity to consume (MPC), as individuals may save a portion of the tax cut. Conversely, the government spending multiplier is typically larger because the initial spending is fully injected into the economy, causing a more significant shift in the AD curve.
During the 2001 recession, the U.S. Congress enacted a tax cut. This shift in fiscal policy increased consumption, which led to a rightward shift in the AD curve, and ultimately resulted in an increase in real GDP and a decrease in unemployment without a significant rise in the price level, as the economy was not yet at its full employment level of output.