what are the options available under fiscal policy if we are

what are the options available under fiscal policy if we are in a contractionary gap? which is more important and why?

Solution

In a scenario of the contractionary gap, actual output is less than the potential output level. In this scenario, there is a need of expansionary fiscal policy. Under this policy, the first option is to increase the government spending, because it boosts the aggregate demand and AD shifts to the right. To cater the increased level of AD, supply increases and new jobs are created. As a result, potential output with full employment (natural unemployment) is achieved. The second option is to reduce the taxes. It will increase the disposable income and consumption will increase. As a result, AD shifts to the right and potential output level is achieved.
Here, the increase in government spending and or decrease in taxes, cause the multiplier effect. Though, the spending multiplier is bigger than the taxation multiplier. Hence, it is important to apply the first option that is to increase the government spending. It makes a direct impact to the output and employment. Though, care is to be taken to not to discourage the firms via crowding out effect.