The Economics of Recession: A Survey
Part 4/10, September 2022 [1]
Arturo Estrella

4. How do recessions end?

          If monetary policy is the focus of many theories about how recessions begin, fiscal policy tends to be the main focus as to how they end. Yet, monetary policy is not completely discounted as a means of ending a recession. John Taylor [20] argues that “… when the economy starts into recession, sharp and rapid interest-rate declines are appropriate.” In fact, the celebrated Taylor Rule, unveiled in this article, is in part a mechanism for monetary easing when output falls below potential, and Taylor argues directly that following this technique can “help mitigate recessions.”

          However, the use of fiscal policy to escape recessions is a much more prevalent argument, particularly since Keynes published his “General Theory” in 1936. During the 2008-09 recession and its aftermath, no economist has been a more vocal proponent of fiscal stimulus than Paul Krugman. In an article [21] published even before the recession, we find him arguing for a return to an old-fashioned Keynesian approach to fiscal policy. In particular, he suggests that fiscal stimulus is a useful tool when policymakers are facing prolonged economic slumps. He uses the example of Japan to illustrate his point, but the period of sluggish growth that outlasted the subsequent recession in the United States affords further opportunities to consider this policy prescription.

          Auerbach and Gorodnichenko [22] address the question of whether fiscal policy is more or less effective in recessions than in expansions. They employ a statistical methodology based on Markov switching and find that fiscal policy is not only helpful in extricating an economy from recession, but that fiscal multipliers for some types of government spending – the aggregate effect on the economy per dollar spent – are in fact higher during recessions. For example, the multiplier for military spending is estimated to be the largest. These results suggest that fiscal policy is especially effective in attempts by policymakers to end a recession.

Readings referenced from book The Economics of Recession

R20    John B. Taylor (1993), ‘Discretion versus Policy Rules in Practice’, Carnegie-Rochester Conference Series on Public Policy, 39, December, 195–214

R21    Paul Krugman (2005), ‘Is Fiscal Policy Poised for a Comeback?’, Oxford Review of Economic Policy, 21 (4), Winter, 515–23

R22    Alan J. Auerbach and Yuriy Gorodnichenko (2012), ‘Measuring the Output Responses to Fiscal Policy’, American Economic Journal: Economic Policy, 4 (2), May, 1–27

[1] The original version of the survey was published in The Economics of Recession, Edward Elgar Publishing, 2017.