Discuss the most effective policy approach during a time of recession, and where a country has a fiscal deficit (30 marks)
A recession is when an economy experiences two consecutive quarters of negative economic growth measured by real GDP. A fiscal deficit is when government spending is greater than what is received through tax receipts.
One policy to reduce the fiscal deficit and attempt to effectively deal with the recession would be to lower taxes such as VAT, this is an example of an expansionary fiscal policy. VAT is an indirect tax placed on consumption such as purchasing of goods and services. For the government to reduce VAT, it would increase consumption because all the goods and services within the economy become cheaper as a portion of the price is removed. With consumption being the main component of aggregate demand (C+I+G+(X-M)), it will cause an outward shift as shown below where AD rises to AD1. However, this depends on how much the VAT is reduced by. If it is only cut by a small amount for example 0.5% compared to the UK cutting the interest rates from 17.5% to 15% it may have limited impact on AD therefore the fiscal deficit will not improve by much. Also, firms may wish to absorb the cut in VAT as decreasing VAT will result in high menu costs. Firms may be able to sustain higher profits if they do not change their prices however if competitors do cut their prices it is likely consumers will go to them.
Another policy that may be used to reduce the fiscal deficit is reducing interest rates. Interest rate manipulation is used by the monetary policy committee to stimulate spending or saving within an economy. By cutting interest rates, spending is encouraged and therefore consumption will rise. Consumption is the largest part of AD and thus AD will increase. The MPC may choose to do this as interest rates are flexible and easy to change month by month showing near immediate effect. It is likely that falling interest rates will lead...
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