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.

2. The Use of Fiscal Policy to Stabilize the Economy

Changes in Transfer Payments

Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments will thus shift the aggregate demand curve because it will affect consumption. Because consumption will change by less than the change in disposable personal income, a change in transfer payments of some amount will result in a smaller change in real GDP than would a change in government purchases of the same amount. As with income taxes, a $200-billion increase in transfer payments will shift the aggregate demand curve to the right by less than the $200-billion increase in government purchases that we saw in Figure 12.9 "An Increase in Government Purchases".

Table 12.1 "Fiscal Policy in the United States Since 1964" summarizes U.S. fiscal policies undertaken to shift aggregate demand since the 1964 tax cuts. We see that expansionary policies have been chosen in response to recessionary gaps and that contractionary policies have been chosen in response to inflationary gaps. Changes in government purchases and in taxes have been the primary tools of fiscal policy in the United States.

Table 12.1 Fiscal Policy in the United States Since 1964

Year Situation Policy response
1968 Inflationary gap A temporary tax increase, first recommended by President Johnson's Council of Economic Advisers in 1965, goes into effect. This one-time surcharge of 10% is added to individual income tax liabilities.
1969 Inflationary gap President Nixon, facing a continued inflationary gap, orders cuts in government purchases.
1975 Recessionary gap President Ford, facing a recession induced by an OPEC oil-price increase, proposes a temporary 10% tax cut. It is passed almost immediately and goes into effect within two months.
1981 Recessionary gap President Reagan had campaigned on a platform of increased defense spending and a sharp cut in income taxes. The tax cuts are approved in 1981 and are implemented over a period of three years. The increased defense spending begins in 1981. While the Reagan administration rejects the use of fiscal policy as a stabilization tool, its policies tend to increase aggregate demand early in the 1980s.
1992 Recessionary gap President Bush had rejected the use of expansionary fiscal policy during the recession of 1990–1991. Indeed, he agreed late in 1990 to a cut in government purchases and a tax increase. In a campaign year, however, he orders a cut in withholding rates designed to increase disposable personal income in 1992 and to boost consumption.
1993 Recessionary gap President Clinton calls for a $16-billion jobs package consisting of increased government purchases and tax cuts aimed at stimulating investment. The president says the plan will create 500,000 new jobs. The measure is rejected by Congress.
2001 Recessionary gap President Bush campaigned to reduce taxes in order to reduce the size of government and encourage long-term growth. When he took office in 2001, the economy was weak and the $1.35-billion tax cut was aimed at both long-term tax relief and at stimulating the economy in the short term. It included, for example, a personal income tax rebate of $300 to $600 per household. With unemployment still high a couple of years into the expansion, another tax cut was passed in 2003.
2008 Recessionary gap Fiscal stimulus package of $150 billion to spur economy. It included $100 billion in tax rebates and $50 billion in tax cuts for businesses.
2009 Recessionary gap Fiscal stimulus package of $784 billion included tax rebates and increased government spending passed in early days of President Obama's administration.
2010–2012 Recessionary gap Extensions of the payroll tax reduction and unemployment insurance benefits continued.