The current recession the United States is experiencing began several years ago when business owners and CEO's were afraid that the sudden trend of bad business would continue, so they started to slow investments, put expansions on hold and reduce inventory. This had the effect of increasing unemployment and further reducing business. Workers started to get laid off, got less bonuses and overtime, and so began to spend less money. Because they saw businesses being hurt, consumers became wary and started buying less. All of these actions made the economy continue in a downward slide.
The role of fiscal policy is to counteract undesirable trends-- to push the economy out of recession and to slow it down if it becomes overheated and inflation occurs. If the economy is headed downward into a recession, fiscal policy is often used to stimulate the economy. This is what Keynes came up with in the midst of the Great Depression of the 1930's, when unemployment rates in the U.S. exceeded 25% and the growth rate of real GDP declined steadily for the next decade. He and his followers believed that the way to combat the prevailing recessionary climate was not to wait for prices and wages to adjust but to engage in expansionary fiscal policy. This is how they thought:.
In looking at a graph, (attached), we see that the equilibrium level of GDP, (Y1), lies below the natural level, (Y2). This implies that there is less than full employment of the economy's resources. Classical economists believe that the presence of unemployed resources causes wages to fall, reducing costs to suppliers and causing the aggregate supply curve to shift from AS1 to AS2, restoring the economy to full employment. Keynesians would argue that wages would not adjust quickly enough to reflect the reality of unemployed resources. Also, the recessionary climate could persist for a long time. According to Keynesian thought, you can combat this problem by running a budget deficit by increasing government expenditures in excess of current tax receipts.
