Business Cycles The Keynesian approach to recessionary gaps is to increase government spending and lower taxes -- run a deficit -- in order to spur aggregate demand. In the Keynesian model, aggregate demand is affected by a number of different factors -- consumer consumption, business investment, government spending and net exports. During a recessionary gap, consumer spending and business investment are probably both down, which leaves the other two factors to prop up the economy. Government spending is an efficient way of directly putting money into the economy, thereby giving consumers more money to spend and businesses more money to invest (FRBSF, 2013). Knowing that the government is working hard to spur economic growth can also change the underlying psychology of the market.

Lowering taxes is another means by which government can spur growth under this scenario. Lowering taxes allows for more spending from both consumers and businesses, since both will have more money to spend. The approach of lowering taxes is less efficient than increasing government spending (Uchitelle, 2009), however, when there are other factoring contributing to the recession, such as higher consumer savings rates. When aggregate supply is higher than aggregate demand, lowering business taxes is not likely to spur investment because businesses are not using the capacity they have -- steps to spur exports would help close the AD-AS gap, but those policies take more time to come to fruition.

The neoclassical approach is to eschew government intervention. This approach holds that the market will self-correct. The approach does not specify how this will happen, just that the market is always right and better than the government (Yergin & Stanislaw, 1998). Whatever power the market has to achieve superior results, those results are achieving only in the long-run, on aggregate. Thus,...

The common prescription is to lower interest rates, lower taxes and lower regulations. Lowering interest rates helps put more money into the economy. This is valuable if the economy needs the money, but when AS is higher than AD, the economy has no use for excess capital. Lowering taxes has a similar problem, although lowering taxes on consumers can spur AD, if consumers are not otherwise overleveraged and are willing to spend the fruits of these lower taxes. Lower regulations can spur business investment, but will only do so where AD is higher than AS.
2. The past recession lends clear support for the Keynesian position. Faced with specific conditions where consumers and businesses are unlikely to increase spending, government is left to intervene in order to spur economic growth. On a smaller scale, the same occurs following a natural disaster. With consumers and businesses having their wealth wiped out by a hurricane/earthquake/tornado, some will be able to spend on rebuilding but a great many will not. Government intervention in the form of funds to rebuild critical infrastructure and provide financial relief for victims helps to spur economic recovery in the area, complementing the private investment from those who can afford it.

There are fewer instances where the classical theory holds. Elements of the classical theory, such as the benefits of lowering interesting rates, lowering taxes and reducing regulation, all have been proven in the real world. The major issue that fails is the one stemming from 1950s anti-socialist ideology -- that government intervention is inherently bad and cannot help an economy. Lowering interest rates (and other forms of expansionary monetary policy) have enjoyed successes in many instances, especially during minor downturns. The recession sparked by the…