Which among the following steps is most likely to be taken at the time of an economic recession?

1. Cut in tax rates accompanied by increase in interest rate
2. Increase in expenditure on public projects
3. Increase in tax rates accompanied by reduction of interest rate
4. Reduction of expenditure on public projects

Explanation

Option (b) is correct

• During an economic recession, the economy experiences a slowdown in growth, reduced consumer spending, lower business investments, and rising unemployment. To counter these effects, governments typically adopt expansionary fiscal policies to stimulate economic activity. Technically (there is no official definition of recession), a recession means that the total output in the economy — measured by the Gross Domestic Product or GDP — contracts for two consecutive quarters. A quarter is a period of three months.
• Increase in expenditure on public projects is the most likely step to be taken during an economic recession.
• Stimulating Demand: Increasing expenditure on public projects, such as infrastructure development, directly injects money into the economy. It leads to increased government spending, which creates jobs, boosts income, and increases consumer spending power. This process is known as the multiplier effect, in which initial spending generates more economic activity than the amount initially spent.
• Addressing Unemployment: Public projects, like building roads, schools, and hospitals, typically require a large workforce, thus helping to reduce unemployment levels. As more people find jobs, their disposable income rises, leading to greater consumer spending, which can help lift the economy out of recession.
• Boosting Private Sector Confidence: Increased government expenditure can also instil confidence in the private sector. When businesses see that the government is taking steps to revive the economy, they may be more inclined to invest and expand operations, further contributing to economic recovery.
• Counteracting Reduced Private Spending: During a recession, private consumption and investment often decline. By increasing public expenditure, the government compensates for reduced private-sector spending, helping maintain overall demand in the economy.

Option (a) is incorrect

• While cutting tax rates can increase disposable income and boost consumer spending, an increase in interest rates would have the opposite effect. Higher interest rates discourage borrowing by making loans more expensive, reducing consumption and investment. Raising interest rates during a recession would counteract the benefits of a tax cut, making this option counterproductive.

Option (c) is incorrect

• Increasing tax rates during a recession is typically avoided as it reduces disposable income, thereby decreasing consumer spending and potentially worsening the recession. Although a reduction in interest rates can encourage borrowing and stimulate investment, the negative effects of increased taxes would likely outweigh the benefits, leading to further economic contraction.

Option (d) is incorrect

• Reducing expenditure on public projects is a contractionary fiscal policy and is not suitable during a recession. Lower public spending would mean fewer jobs, lower incomes, and reduced overall demand. This would deepen the recession by exacerbating unemployment and reducing economic activity

Answer: (b) Increase in expenditure on public projects; Difficulty Level: Easy