1. Fiscal Policy
The government can increase AD through cutting tax rates and / or increasing government spending. Lower income taxes give consumers greater disposable income, therefore consumption and economic growth increases. Expansionary fiscal policy involves a larger budget deficit.
It is interesting to note that most Presidential candidates seem to support some kind of fiscal stimulus package, with candidates either calling for lower taxes and / or government spending.
Some evaluation of the effectiveness of fiscal policy:
- Some taxes will have more effect on increasing spending. e.g. if you cut tax for the rich spending it will only increase a little because they have a high marginal propensity to save.
- Depends on Confidence. If people are pessimistic about the future, tax cuts may not be spent but just saved see Keynes' paradox of thrift.
- Depends on National Debt. In the US, the National debt is already 65% of GDP, this reduces scope for expansionary fiscal policy because if the government borrows more it may put upward pressure on interest rates. It will also further increase future interest payments.
- Crowding out. Crowding out can occur when public sector spending reduces private sector spending. i.e. because government sell bonds to private sector, the private sector have less money to spend. Keynesians say this crowding out does not occur in a recession because resources are wasted and are not being used.
2. Monetary Policy
Expansionary monetary policy. If the monetary authorities cut interest rates it will make it cheaper to borrow and therefore, should encourage consumption and investment. In the US some are talking of the Fed cutting interest rates to 1%
However, this may conflict with targets for inflation. e.g. rising energy and food prices is leaving Central banks less room for cutting interest rates.
It may also effect the exchange rate. e.g. if US interest rates were cut it would cause a further devaluation in the dollar.
3. It depends on things beyond the control of the government.
In the US, the future of the economy depends on how the housing market responds. If house prices keep falling then lower interest rates may be insufficient to boost spending and growth in the economy. It also depends on international factors like how much demand there is from other countries.
Basically government can try but there is no guarantee it will work. Some economists even suggest recessions can be necessary. i.e. if banks are bailed out for making bad loans they will continue to make them in the future.