Fiscal Policy: The Best Case Scenario

In this video, we explore when and why the government might engage in expansionary fiscal policy. Specifically, we’ll discuss why the government might increase spending, or decrease taxes, to combat a recession.

Think about an economy during a recession. Consumers are spending less. Aggregate demand is down. And we’re looking at negative growth. In the long run, the economy will adjust. But in the short run, sticky wages and prices leave a lot to desire.

In this case, the government has some options. It could do nothing and wait for the economy to bounce back – a slow and painful process. Or it could reduce taxes or increase spending.

The spending option has the potential to increase the velocity of money and thereby increase aggregate demand. This will, at least in the short run, increase real growth and help ease the pain of the recession.

This may all sound really simple. But consider the reality of implementing fiscal policy: You’re shifting around resources in a multi-trillion dollar economy. Like monetary policy, it’s hard to get fiscal policy just right. We’ll delve deeper into these complications in the next video.