Typical Recessions - Essay Example

Observe that the equilibrium output has fallen to Y2 implying recession, and the price level has increased to P2 implying inflation.

This movement from equilibrium A to B is the phenomenon of stagflation.

2. The immediate impact of a reduction in taxes is an increase in aggregate planned consumption expenditure, a component of aggregate demand. Thus, aggregate demand increases implying a rightward shift in the AD curve. However, whether this would lead to a substantial economic expansion (growth) or inflation with some minor growth depends upon where the economy is located on the business cycle when the policy is undertaken. We shall consider two cases: (a) when the economy is in recession and (b) during a boom.

Case (a) effect of tax cuts during the recession:

Figure 2: Effect of tax cuts in AS-AD framework case (a) during the recession

As is evident from the diagram above, the tax cuts led to the AD curve moving from AD1 to AD2 which in turn led to an expansion of Y from Y1 to Y2. There is a negligibly small increase in the prices from P1 to P2. Thus, during a recession or the phase of recovery, tax cuts can yield substantial growth.

Case (b) tax cuts during the boom:

Figure 3: Tax cuts further ing boom

During a period of economic expansion or the “boom” phase of the business cycle, the tax cut on the other hand hurt the economy. This is shown in the diagram above. Observe that now the outward shift in AD has led to a substantial rise in the price level while the increase in real output has been small. The closer the economy gets to the full-employment more effective does the tax cut becomes in stimulating growth and most of the impact of the resulting rising demand is reflected instead in rising prices.

Essentially, during the race, sign the economy is located far out of all-employment equilibrium and thus has surplus unused capacities. So, when the aggregate demand rises, the capacity utilization rises and so employment and output rise while prices stay more or less the same. However, when the economy is in a boom and is located close to full-employment equilibrium, there are no unused capacities. As a result, when aggregate demand increases, the output cannot increase and this leads instead to a rise in prices leading to demand-pull - inflation.