Government and Fiscal Policy

Read this chapter to learn about how the government's fiscal actions influence aggregate demand. The chapter first introduces the components of the government's budget and then discusses discretionary fiscal policy and automatic stabilizers used to influence the economy. Some lags in the implementation of fiscal policy are identified and the concept of crowding out is introduced. Attempt the "Try It" exercises at the end of the section.

1. Government and the Economy

Government Purchases

The government-purchases component of aggregate demand includes all purchases by government agencies of goods and services produced by firms, as well as direct production by government agencies themselves. When the federal government buys staples and staplers, the transaction is part of government purchases. The production of educational and research services by public colleges and universities is also counted in the government-purchases component of GDP.

While government spending has grown over time, government purchases as a share of GDP declined from over 20% until the early 1990s to under 18% in 2001. Since then, though, the percentage of government purchases in GDP began to increase back toward 20% and then beyond. This first occurred as military spending picked up, and then, more recently, it rose even further during the 2007–2009 recession.

Figure 12.1 "Federal, State, and Local Purchases Relative to GDP, 1960–2011" shows federal as well as state and local government purchases as a percentage of GDP from 1960 to 2011. Notice the changes that have occurred over this period. In 1960, the federal government accounted for the majority share of total purchases. Since then, however, federal purchases have fallen by almost half relative to GDP, while state and local purchases relative to GDP have risen.

Figure 12.1 Federal, State, and Local Purchases Relative to GDP, 1960–2011

Government purchases were generally above 20% of GDP from 1960 until the early 1990s and then below 20% of GDP until the 2007-2009 recession. The share of government purchases in GDP began rising in the 21st century.