Lu Lu (6500354)                                                                         

How successfully can fiscal policy be used to combat (a) recessions and (b) 'overheating' in the economy? Use examples and evidence to support your arguments.

Business cycle is defined as the alternating periods of expansion and contraction in an economy’s real output (Welch, 2004: 146). Rather than occur randomly, business cycle tends to be regular which goes through four phases: a recovery during which real GDP increases; a peak where maximum output occurs; a recession during which real GDP falls; and a trough where minimum output occurs (ibid.). There is undoubted those economic fluctuations have influential effects on societies. Fiscal policy, which is the governmental policy used to intervene in the macroeconomics by the overall level of government purchases and taxations, is one of the most important policies used to maintain the stabilisation of the economy (Case and Fair, 1999: 583). Recession and overheating can be seen as the main targets that the fiscal policy tends to deal with (Mankiw, 2005: 723). Critically, it seems to be successful to combat recessions and overheating by fiscal policies, but there are also several limitations.

Recession is a period in which the economic growth rate is far below the normal, according to Frank and Bernanke (2004: 645). During a recession, people have fewer stimuli to consume and invest, and the unemployment rate tends to rise rapidly. The causes of recession seem to be complicated. Keynes (Schiller, 2005: 265-267) has developed a theory that pays attention to the demand-side. In his view, people’s expectation plays an important role in short-run recession. If people tend to be more pessimistic about the future, the economy, therefore, is likely to suffer a recession (Mankiw, 2005: 732). In order to overcome this demand-pull recession, the government should implement an expansionary fiscal policy by either increasing the government expenditure or reducing the taxes in order to stimulate the investment and consumption. (McConnell and Brue, 2002:225). Illustrate an example of intense recession in US 2003. Concerned about the deflationary gap, President Bush advocated a tax cut of 100 billion US dollars in 2003 and a further 670 billion cut over the ten years (ibid.). Meanwhile, the federal government spending had reached to 20,000 US dollars per household, the highest level of federal spending since World War II (Riedl, 2003). As a result, the GDP growth rate was 5.4 percent during the three quarters after its passage, compared to -1.81 percent before the cut tax, while the unemployment rate dropped by 1.0 percent (Beach, et,al. 2004). It is clear indicated that the federal government has been successful in combating with the recession by expansionary fiscal policies.

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Although expansionary policy seems to be a good approach to fight with recession both in theoretic and empirical dimensions, there are many critiques about its effects in reality. One argument is the time lags. According to Miller (2001: 308), these lags can happen during the time of recognising recession, the time between recognition and policy implementing and between the implementing and effects. Another argument is the trade-off between short-run and long-run effects. According to Weil (2002), expansionary policy may lead to higher output today but lower the productivity below what it would have been in the future. In his ...

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