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Understanding the tools of fiscal policy.

Assume that the economy is already in a recession, and both the President and Congress have decided to do something to restore the economy. Both agree that lowering taxes would not be a good idea, but do believe that it is in the best interest of the economy to increase government spending in defense, education & infrastructure.

The President and Congress change the budget accordingly, but after 18 months, GDP only increased by three quarters of the expected amount. What factors might be responsible for this situation?
State the tools of fiscal policy and how they are used to reduce inflation or eliminate a recession.

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Solution Preview

The first part of this question is a classic example of crowding out. Recall the national income accounting identity.
If the government increase expenditure on defense, education and infrastructure this may increase the ...

Solution Summary

The following outlines a scenario where the government has increased spending to move an economy out of recession. A discussion is provided on the crowding out effect and how it may limit the governments efforts.