Macro Policies 30 Marker

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 to a devaluation of the currency, this is due to hot money flows leaving the economy as people will save their money abroad where the interest rates are higher and the country will see less hot money coming in due to a less of a beneficial returns from storing the money in the bank. This will lead to exports increasing as the goods from that country become cheaper, which is a component of AD so it it likely the multiplier effect will occur.
However, this may have limited effect depending where the current rate of interest lies and also the amount of which interest is cut by. If the current rate is 0.5%, cutting interest rates further to 0.4% will have a limited impact. It is also very broad int terms of the scope of people it will impact. Interest rates will affect everyone, as it may become beneficial for firms, it will not be beneficial for pensioners and other savers who will not see as much of a reward for saving as they previously did.

Also, increasing government spending in the public sector through wages may also reduce the fiscal deficit, before initially increasing it. This is an example of an expansionary fiscal policy and government spending is a component of AD, as shown below it will cause AD to increase to AD1. Government spending on public sector wages such as teachers will likely result in consumption increasing from the public sector workers as they will have money disposable income to spend, leading to the multiplier effect raising AD to AD1 then finally AD2 as shown in the diagram below.
Finally, quantitative easing may be used as a way to reduce the fiscal deficit. Quantitative easing is a form of monetary policy in which the central bank creates new money in the form of government bonds which are given to banks. This encourages banks to lend money and therefore increases spending within the economy as more loans are taken out due to increased consumer confidence and the banks willingness to lend. This will result in AD increasing through consumption increasing (a main part of aggregate demand). Therefore the fiscal deficit will be reduced.
However, in the long run with a greater supply of money in the economy it may lead to hyper inflation in which the value of the currency becomes too weak.??