Discuss what government policies can be used to overcome a recession A recession is two or more consecutive quarters of a year that experiences a decline in GDP or has negative GDP growth; recessions are believed to be caused by a widespread fall in spending. Employment, investment, household incomes and business profits all fall during recessions; while bankruptcies and the unemployment rate rise.
Governmennts respond to recessions by adopting expansionary economic policeys such as the expansionary fiscal policey or loose monetary policey. The exapansionary fiscal policey involves the government attempting to increase aggregate demand, the two main instruments the government use to achieve this is government spending and taxation.
The government increases its spending in the economey which stimulates the economey through the multiplyer effect, this huge increase of government spending acts as an injection into the circular flow and will eventually increase consumer incomes which will increase the consumers marginal propensity to consume which will therefore shift aggregate demand to the right as all of this additional income is being spent, this right shift will then lead to an increase in economic growth, this is shown on the graph below.
However the effect of the fiscal policy will depend on how much money is pumped into the economy and how much the taxes have been reduced because if government spending has increase by a small percent or taxes have decreased a small percent it may not have much of an effect on the consumer marginal propensity to consume and so may fail to increase aggregate demand. Also depending on the inflation rate in the economy already the fiscal policy could cause the price level to increase due to a major increase in aggregate demand as shown in the graph above.
Also the policy could cause crowding out because if the increase in government spending is raised from taxes then it would lead to a reduction in private spending and if the increase is financed by borrowing then it could lead to a rise in interest rates which would lead to a decrease in private investment. There will also be a time lag involved as the government will have to wait for the multiplier effect to kick in and so in the short term this policy may prove ineffective however in the long term its effectiveness will show.
Another policy the government can use is the expansionary monetary policy, the expansionary monetary policy aim to shift aggregate demand to the right by lowering the interest rates, the lowering of the interest rates lowers the cost of borrowing for example using credit cards and decreases consumers marginal propensity to save which therefore encourages consumption. These lower interest rates also encourage firms to borrow and invest therefore further increasing aggregate demand in the economy.
These lower interest rates will therefore increase aggregate demand shown in the graph below. This increase in aggregate demand will therefore increase GDP as shown in the graph above. However the amount the government can decrease the interest rates by will depend at what level they are at already, for example the interest rate for the UK at this moment of time is 0. 5 and so the government would not realistically be able to decrease this any more and so the monetary policy would prove ineffective in this situation.
So if the decline in interest rates does not work the monetary policy uses the tool of qauntative easing which is were the MPC “monetary policy committee” creates money through selling bonds, buying banks assets and selling loans to other banks, this money is then spent in sectors of the economy which will act as an injection into the circular flow, this will then again generate growth as it will cause aggregate demand to shift outwards.
This increase in cash reserves due to the selling of bonds and so on will also mean banks will increase their lending to households and businesses which will again make it easier for people to obtain money and therefore consume therefore shifting aggregate demand to the right causing and increase in growth.
Although the use of this policy could also cause inflation as shown in the graph above, the MPC also predict the future economic trends so the policy can be used at full effect and so if the prediction is wrong it could have negative effects on the economy, furthermore the effect of the qauntative easing will depend on how much the MPC is actually able to obtain through bonds, selling loans and acquiring bank assets.