Markets and the Economy - Term Paper Example

These built-in stabilizers are: transfer payments and income taxes. During economic downturn, government employs loose fiscal policy in order to increase aggregate demand which leads the economy towards recovery. The government offers subsidiaries to the business sector in order to reduce the level of unemployment. The tax cut increase the profit at the cost of decrease government revenue. According to the Keynesian economists, an expansionary fiscal policy employed by the government during the recession could stabilize the economy.

This is so because as the result of this policy aggregate demand will increase that will stimulate the passive economy. This point of view of loose fiscal policy is rejected by many economists on the ground that the increase in aggregate demand (AD) will generate the crowding out situation in an economy. A crowding out situation means the fall in the spending of the private sector as the result of increased government spending. However, this rejection is ruled out by the counter argument that ‘crowding out’ will not formulate because the government will increase its spending only by using its previously unemployed resources.

IS curve is a curve that is formed to show a negative relation between the interest rate and the income. During the time period of recession, the effectiveness of the fiscal policy depends on the sensitivity of IS curve. The effect of the fiscal policy will be greater in case of steeper IS curve whilst it will be less in case of flatter IS curve. Thus, in case of inelastic IS curve (steeper) the fiscal policy will be effective due to a little crowding out of the private investment. Khan (2010) indicated in an article that it is important for economies to keep deficit as low as possible in order to be able to meet the deficit by use of domestic resources or by borrowing from international fund providers.

A low budget deficit helps an economy to become stabilized early by meeting