Should the Government Use Fiscal or Monetary Policy to Eliminate Canada's Current Contractionary Gap?

Should the Government use Fiscal or Monetary Policy to Eliminate Canada’s Current Contractionary Gap?

Introduction

An economic recession is a period of slow economic activity; this contractionary phase is characterized by high unemployment and low levels of GDP. On the other hand, government bodies desire economic growth and low unemployment levels in order to attain a stable economy. These goals may be reached through the use of either fiscal policy or monetary policy. This paper will focus on and discuss which policy is more effective in eliminating the current recessionary gap of Canada.

Arguments for Fiscal Policy

Fiscal policy is the “deliberate, discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals”. Fiscal policy results in an increase of government expenditures. When government expenditures are increased, the gross domestic product increases as well. This is particularly important during the recessionary phase of the business cycle. For example, many economists believe that “government spending on [World War II] caused… recovery from the Great Depression”. The increase in war-related expenditures by the government allowed economic growth to double in countries all over the world.

When taxes are decreased through fiscal policy in an economic recession the citizens will have a greater disposable personal income. When there is a greater disposable personal income this will allow consumption to increase due to the money saved from the lower tax rate. Through consumption increasing this will favour economic because the gross domestic product has increased. When government expenditures are increased it will have a multiplier effect on aggregate demand. Because of the multiplier effect, the government can increase spending by only a small amount to achieve a larger, necessary increase in aggregate demand. By doing so, the economy will be able to attain an equilibrium level of real GDP.

One of the main focuses in Canada right now is employment and fiscal policy seeks to reach full employment. When there is an increase in employment, economic activity increases as well. This allows for a move towards full employment, economic growth, and little inflation. Therefore if fiscal policy is used wisely, it will put the nation in the correct direction.

During a recessionary period, people may look at protection by building up liquid assets from risk of unemployment and other losses by “sleeping” on their money, or saving it in a place other than in a chartered bank. In the same way, banks may hold onto excess reserves for fear that people may default on their loans. Doing so decreases money supply in an economy; however, this does have any effect on fiscal policy, thereby making fiscal policy a more suitable action than monetary