According to the fiscal policy chapter 11, a recession gap occurs when the economy experiences a recession, a situation when there is a lower real gross domestic product GDP than the economy’s full-employment level. This leads to a lower money circulation among the workers in an economy hence low expenditure and investments by the consumers.
As discussed in chapter 11, this can be curbed by increased government purchases. When the government increases their purchases with the taxes held constant, they therefore add much money to the public, they increase the money circulation in the economy. This has a consequential effect of increasing the workers expenditures as well as their investments. The real GDP will therefore be higher than the potential GDP thereby doing away with the recessionary gap. The economy will therefore not operate below the full employment level.
A tax cut on the other hand as the name suggests, is a reduction in the taxes levied by the government. When the government reduces taxes, there will be a reduction in the government’s real income and a consequential increase in the real income of the consumers or workers whose taxes have been reduced(Hansen, 2003). This increases the workers potential to spend and invest in various businesses in the economy.
A tax reduction will boost the business activities in the economy. If the government allows a tax cut, it will make a budget shortfall. By selling more treasury bonds to the public at a tax cut, the public pay less for more. A tax cut provide for flexibility. The consumers willing to consume or spend more are free to do so using the tax cut. There will be over-investment. The real gross domestic product will therefore rise to the economy’s potential GDP driving an economy out of a recessionary gap.