TD and Goobie:
The state of the economy is mired by a full employment GDP gap, signaling an imbalance in the macro economy. Because we are considering the moment, and immediate future, it does justice to use a short run analysis where aggregate demand determines output (GDP). Due to the fact that prices in the short run are sticky, we are witnessing a discrepancy in what the market wants (falling demand leading to falling supply), and what reality dictates (people do not want their wages, assets, etc... to fall to equilibrium).
So we have a couple options. The first is that we allow prices to fall and the market to self correct. Sounds good, but what does that encompass exactly? High unemployment (not 10%, more like 20%-30%) where firms downsize, capital investment diminishes (high savings and interest rates), assets devalue (to attract buyers); which will cause the dollar to appreciate leading to greater purchasing power (it cost less dollars to purchase the same goods). Now you might say, "yeah, that sounds good", but does it really? If you own a home, it is now worth less than a year ago. As unemployment climbs, people will be willing to work for less (decreased wages). Borrowing money is now expensive because people/businesses are worried (higher interest rates). So now not only do we begin to experience lower wages, higher interest rates, and devalued assets, the majority of the economy still has a plethora of fixed cost obligations regardless of market sentiment (mortgages, credit cards, auto loans, business loans, health care, education costs, etc...)
To put it simply, everyone will suffer.
The alternative? The government runs deficits and begins to apply policies that will positively shift demand (stimulus, specifically government spending not tax rebates). In accordance, central banks go against market sentiment and begin flooding the financial system with liquidity thereby lowering interest rates and preventing a race to the bottom in asset prices (money is not scarce now). Inflation (higher prices) is sought as a way to cure falling asset prices (deflation) because costs in the short term are "fixed". As the psychology of markets leans towards optimism, prices will begin to rise (a signal of naturally improving demand) and these higher prices will attract producers to hire more workers which is necessary to increase production, in accordance with increasing capital spending (business investment) which is interest rate sensitive.
Once we see consecutive quarters of positive GDP growth, higher employment, greater lending, more monetary velocity; central banks will begin the necessary steps in draining excess liquidity, thereby raising rates (carefully). In accordance, the federal government (with careful timing and consideration) begins raising taxes on in a temporary fashion (to ensure the Ricardian equivalence holds).
All in the short run. We are now beginning to see real signs of improvement. There might be some more bumps in the road, but that is to be expected when "animal spirits" are released.
However in the long run, real growth is primarily a function of increased productivity via technological progress. In the long run, it is aggregate supply that determines real output (GDP).