A recessionary gap is defined as the gap between the level of real Gross Domestic Product or GDP and potential output when real GDP is less than potential output (Rittenberg, 2009). This means that aggregate demand, GDP and price level decline, while unemployment rises. Aggregate demand is the relationship between price level and real quantity of domestically produced final goods and services. Aggregate demand consists of spending on real GDP. Success can be achieve through consumer spending, investment spending, government spending and net exports (OSWEGO, Macroeconomics). An increase in any of these areas of aggregate demand will raise GDP, raise price levels and lower the unemployment rate.
This will push the economy into an expansionary period in the business cycle. Governments sometimes use stabilization policies to move economies to their potential output. In a recession, they can use expansionary fiscal policies to influence economic activity through government purchases, transfer payments and tax levels (Rittenberg, 2009). Deficit spending is when a government’s expenditures exceed its revenues. The government’s excess spending should be financed through borrowing. More than likely, this borrowing is from foreign governments.
The increased government spending can jump start an economy that is in a recessionary gap by pumping money in, but it can also have adverse effects by raising interest rates and crowding out the private sector that might have borrowed for capital investments.
During a recession, normal unassisted adjustment can be slow and high rates of unemployment can last too long. Deficit spending can assist in bringing the economy back to equilibrium in a shorter period, lessening the effects of recession. John Maynard Keynes was a huge advocate for deficit spending as a fiscal policy tool to help moderate or end a recessionary period.
During a recession, government spending can stimulate business activity, create jobs and bolster consumer spending. Keynesian economics the use of countercyclical fiscal policies to keep the economy balanced.
What this means that if the economy is expanding, the government should institute progressive taxation to keep consumer spending in check. Or in a recession the government should spend more money on infrastructure to bolster the economy (Danby). This countercyclical policy includes capital expenditures. Capital expenditures are expenditures that create future benefits. For example, the government borrows money to build a new highway.
While building the highway, they increase consumer spending, government spending and create jobs. Once the highway is built, the government can then create additional taxes for the use of the highway to help recoup their expenses, or at least pay the interest on the borrowed money (Danby).
However, there are disadvantages to deficit spending. Spending money that you do not have can effectively increase the cost of everything that you buy. Transferring one debt to another to maintain deficit spending can have a compounding effect where interest accumulates on previous interest essentially driving up the prices of goods and services. This creates a budgetary burden of higher interest payments (Danby).
Additionally, countercyclical policies can have the opposite effect of what was intended. Fiscal policies can sometimes take months or even years to fully take effect. By this time, the economy could have met natural equilibrium, thus pushing an economy that has entered into an expansionary period into a recessionary one. Deficit spending can also cause a crowding out effect. Crowding out is when government spending replaces or drives down private sector spending.
Crowding out occurs when the government finances projects through deficit spending with borrowed money. When the government borrows such large amounts of money, this raises interest rates. Having higher interest rates dissuades individuals and businesses from borrowing, consequently decreasing their spending and investment activities (Danby).
Deficit spending can be helpful to encourage short term growth in the economy. However, deficit spending really only puts a band aid on the problem. While government spending increases and creates short term unemployment relief, in the long term it raises taxes and interest rates which lead to lower consumer and investment spending. When consumer and investment spending decrease, unemployment begins to rise and the economy shifts back to a recessionary period. Though the recessionary period may be longer, if a nonintervention policy is assumed the economy will become balanced again.
OSWEGO. Chapter 9 notes. (n.d.). Macroeconomics. Retrieved June 19, 2014, from http://www.oswego.edu/~economic/eco200/chap9.htm
Rittenberg, L., & Tregarthen, T. (2009). Chapter 7: Aggregate Demand and Aggregate Supply. Principles of Macroeconomics. Flat World knowledge, Inc.