A. Explain how automatic stabilisers help smooth out short term fluctuations of the business cycle.

Automatic stabilisers are factors that automatically, without any action by the government authorities, work toward
stabilising the economy by reducing the short term fluctuations (boom and recession) of the business cycle. A business
cycle is marked by the alteration of phases of expansion and contraction in aggregate economic activity. The downturn
in the business cycle is referred to as a recession (contraction of the economy) and the upswing of the business cycle is
referred to as a boom (expansion of the economy). Automatic Stabilisers act to stabilise the economic cycles. These
policies take more money out of the economy as taxes during periods of rapid growth and higher incomes. The money
is then back into the economy by government spending or tax refunds when incomes fall. There are two important
automatic stabilisers: progressive income taxes (taxes where the rate increases if the taxable amount increases) and
transfer payments (direct payments from tax money to vulnerable groups who cannot work ) such as unemployment
benefits.

In the case of progressive taxes, when the economy is expanding (upswing in the business cycle), government tax
revenues automatically increase, causing the disposable income (after-tax income) to be lower than it would normally
be. The decrease in disposable incomes decreases aggregate demand and counteracts the economic expansion. When
the economy is contracting (recession), the incomes fall and government tax revenues automatically decline, which
causes the disposable income (after- tax income) to be higher than it would normally be. This increases aggregate
demand and reduces the recession. Therefore, the more progressive an income tax system, the greater the stabilising
effect on the economy.

In the case of transfer payments (payments made by the government to individuals specifically for the purpose of
redistributing income, thus transferring income from those who pay taxes towards those who cannot work and need
assistance) such as Unemployment benefits, during a recession, when real GDP falls and unemployment increases,
unemployment benefits rise. Unemployment benefits are given to the unemployed people because without it, they
wouldn’t spend, and consumption spending would decrease as well as the aggregate demand. With unemployment
benefits, this wouldn’t occur as the unemployed workforce now has means to spend, by stabilising the decrease in
aggregate demand caused by unemployment. When the economy expands, unemployment benefits are decreased as
unemployment decreases, therefore, stabilising the increase in consumption from the unemployment benefits previously
provided.

For example, in 2020 the Coronavirus Aid, Relief and Economic Security Act (CARES) provided unemployment
benefits, direct payments to families and adults, and loans and grants to corporations and local governments in the
United States. The unemployment benefits and direct payments helped increase consumption in order to balance the
downturn fluctuation in the business cycle. Similarly, when the economy is the upswing of the business cycle
(expanding economy), progressive taxes will decrease disposable income, decrease aggregate demand, and contract
the economy, thereby balancing the upswing.

On the business cycle, fluctuations are shown in figure 1, which is the initial outlook of the economy prior to the
provision of automatic stabilisers. The diagram has many peaks (boom) and troughs (recession) and is often away from
the long term growth trend or potential GDP line. This means that the economy is contracting and expanding
(fluctuating). When automatic stabilisers such as the CARES unemployment benefits are provided, vulnerable groups
who are incapable of working, receive income and are able to consume goods, thereby expanding the economy if it is in
a recession. If there is a boom, unemployment benefits can be decreased by the government and thereby contracting
the economy. In figure 2 it can be seen that automatic stabilisers can balance the economy by bringing it closer to the
potential GDP (long term growth trend) line. The fluctuations in the economy appear balanced as the achieved GDP line
becomes flatter.
Figure 1:

Figure 2:

Therefore, while automatic stabilisers such as progressive taxes and unemployment benefits can help smooth out the
short term fluctuations in the business cycle, they cannot be responsible for completely eliminating inflationary and
recessionary gaps on their own. Nevertheless, automatic stabilisers can help reduce the extremity of the economic
fluctuations of booms and recessions.
 B. Compare and contrast the effectiveness of the Fiscal Policy and the Monetary Policy in dealing with
recession.

In the event of a recession, which is an economic contraction, where there is falling real GDP (negative growth) and
increasing unemployment of resources which lasts 6 months or more, active purposeful government intervention is
needed in the economy to influence aggregate demand. These government interventions which act at the discretion of
the government are known as discretionary policies. These policies try to counteract the effects of a recession and bring
aggregate demand to the full employment level of real GDP. There are two types of demand affecting discretionary
policies: fiscal policy and monetary policy.

The fiscal policy is the manipulation by the government of its own expenditures and taxes in order to influence the level
of aggregate demand. Examples of the fiscal policy are tax cuts and increased government spending. Through the fiscal
policy, a recessionary gap can be eliminated and is called an expansionary fiscal policy, as it plays the role of
expanding a contracted economy. The policy works to expand aggregate demand at the level of economic activity. It
may do so by increasing government spending, decreasing personal income taxes, decreasing business taxes, and a
combination of increasing spending and decreasing taxes. Similarly, in the case of a boom, the contractionary fiscal
policy, which works to contract the aggregate demand and the level of economic activity, can be used. Through the
contractionary policy, government spending can decrease, personal income taxes can increase, business taxes can
increase, and spending can decrease while taxes increase. The strengths of the fiscal policy are that it pulls the
economy out of deep recession, deals with rapid and escalating inflation, has the ability to target sectors of the
economy, directly impacts the government spending on aggregate demand, and has the ability to affect potential output.
The weaknesses of the fiscal policy are the problems of time lags, political constraints, crowding out, inability to deal
with supply side causes of instability, in a recession tax cuts may not be very effective in increasing aggregate demand,
and the inability to ‘fine tune’ the economy.

The monetary policy is a policy carried out by the central bank, aiming to change interest rates in order to influence
aggregate demand. Through this policy, during a recession, there is an increase in the money supplied by the central
bank (which is a governmental financial institution). This is also an expansionary monetary policy as the main objective
is to expand aggregate demand and the level of economic activity. Examples of this policy are decreasing the discount
rate, and reducing the reserve ratio. If the opposite were the case, where the economy is suffering from an inflationary
gap, the contractionary monetary policy can decrease money supply by the central bank and contract aggregate
demand as well as the economy. The strengths of the monetary policy are the relatively quick implementations, central
bank independence, no political constraints, no crowding out, and the ability tot adjust interest rates incrementally. The
weaknesses of the monetary policy are time lags, possible ineffectiveness in recession, conflict between government
objectives, and the inability to deal with stagflation (a simultaneous occurrence of inflation and recession, causing
unemployment).

Figure 3 shows the economy in a recessionary (deflationary) gap. The expansionary fiscal policy or easy or easy
monetary policy increases aggregate demand, which is a rightward shift of the AD curve from AD1 to AD2. This shift
closes the recessionary gap. AD1 intersects the SRAS curve at the level of real GDP = Yrecession, which is below the
full employment level = Yp. By lowering the income tax rate, real output increases from Yrecession to Yp and the price
level then increases from Pl1 to Pl 2.

Figure 3:
By the use of the fiscal policy, the government lowers the income tax rate, and increases spending to increase
consumption, leading to an increase in AD, which helps the contracted economy. This results in decreasing the
unemployment rate. However, using the expansionary fiscal policy can result in inconsistencies such as falling
productivity caused by the increased taxes, causing unintentional inflation, and crowding out when the increases
spending without increasing revenues and is forced to borrow (deficit spending). On the other hand, the expansionary
monetary policy is effective when the central bank buys or sells government securities. This increases money supply
and increases consumption, which also increases aggregate demand, expanding an economy from its contracted state.
However, this policy may create a loan making process requiring people to borrow money, and is generally not effective
in pulling the economy out of a deep recession. While the time lags issue is smaller for the monetary policy than it is for
the fiscal, it is not the most effective method for healing an economy from recession.

To sum up, both policies have their strengths and weaknesses, and can be effective in the economy in increasing
aggregate demand and filling the deflationary gap. However, for combating recession particularly, in my opinion the
fiscal policy may be more effective. In the past the fiscal policy has shown to help recessions greatly, an example is the
Great Depression. A major weakness of the monetary policy is the ineffectiveness in a recession, as when in severe
recession some banks may be unwilling to increase their lending because of the fear that the borrowers may be unable
to repay the loans. Therefore both policies are demand affecting discretionary policies and may help the fluctuations of
an economy by adjusting aggregate demand, particularly in the case of a recession