ECON101: Macroeconomic Essentials for Business
Tutorial 7: Section A---Question 2
2. The economy is in a recession and there is a large recessionary gap. How does the government close the recessionary gap? Explain with diagram.
The main ways that government uses to adjust economy are fiscal policy and monetary policy, but if the economy is in a recession, no matter how low interest rates are, people cannot be forced to borrow if they do not have confidence in the economy. Therefore the main way that government uses to close the recessionary gap should be fiscal policy. Explain 1:
When the real GDP (Y1) less than the potential GDP (Yp), a recessionary gap will exist, shown as the range of G in the diagram 1. Then the government will pursues the expansionary fiscal policy, such as to cut in taxes and increase the government expenditure, it shifts AE1 curve upward to AEp curve, and also the real GDP will be increased from Y1 to Yp, then it leads to increased income, so the people are more willing to spend their income to purchase goods and services in the market, as the result of it, the aggregate expenditure will increases from E1 to Ep. Therefore, the government will close the recessionary gap at the new equilibrium ep.
Diagram 1: Potential GDP
When the real GDP (Y1) less than the potential GDP (Yp), a recessionary gap will exist, shown as the range of G in the diagram 2. Then the government will pursues the expansionary fiscal policy, such as a tax cut or an increase in transfer payments increases the consumption expenditure and aggregate demand, it shifts AD1 curve rightward to ADp curve, and also the real GDP will be increased from Y1 to Yp. Therefore, the government will to close the recessionary gap at the new equilibrium ep by the expansionary fiscal policy.
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