How can fiscal policy be used to correct a recessionary GDP gap? What are some complications?
During a recession, national income declines due to lack of spending. Fiscal policy affects output directly though increasing consumption and government spending and indirectly through the tax and government spending multipliers. Equilibrium Y rises or falls by the amount of the change in G times the multiplier. However, taxes and transfers do not affect expenditures directly. They affect expenditures by affecting the amount of disposable income, and so they work their effects through C. Thus if the marginal propensity to consume (MPC) is 0.75, only 75 percent of the change in taxes works its way into the multiplier. Suppose, for example, that the government sector reduces taxes by $1 trillion with the goal of stimulating aggregate production and warding off a business-cycle contraction. This tax reduction increases disposable income by $1 trillion. The household sector spends part and saves part of this income. The division between consumption and saving is based on the marginal propensities to consume and save.
The simple expenditures multiplier, such as that which would be used for government purchases, is the inverse of the marginal propensity to save (MPS). The tax multiplier is rather - MPC/MPS. Thus if the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change in taxes results in an opposite change in aggregate production of $3 trillion. This is because higher taxes reduce income, thus people have less ...
Complications resulting from expansionary fiscal policy