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

Case in Point: How Large Is the Fiscal Multiplier?

There is a wide range of opinions among economists regarding the size of the fiscal multiplier. In 2011, the American Economic Association's Journal of Economic Literature published three papers on this topic in a special section titled "Forum: The Multiplier". The papers provide at least two-and-a-half different answers!

In her paper titled "Can Government Purchases Stimulate the Economy?," Valerie Ramey concludes that the size of the government purchases multiplier depends on many factors but that, when the increase in government purchases is temporary and financed by government borrowing, the multiplier "is probably between 0.8 and 1.5. Reasonable people can argue, however, that the data do not reject 0.5 to 2". This is quite a wide range.

In "An Empirical Analysis of the Revival of Fiscal Activism in the 2000s," John Taylor argues that the various components of the recent fiscal packages (tax cuts, aid to states, and increased government purchases) had little effect on the economy – implying a multiplier of zero or nearly so. Using aggregate quarterly data simulations for the 2000s, he argues that transfers and tax cuts were used by households to increase saving, that the increase in government purchases were too small to have made much of a difference, and that state and local governments used their stimulus dollars for transfers or to reduce their borrowing.

In "On Measuring the Effects of Fiscal Policy in Recessions," Jonathan Parker essentially argues that the statistical models built to date are ultimately inadequate and that we will only be able to get at the answer as better and more refined studies are conducted. Noting that the multiplier effect of fiscal policy is likely to depend on the state of the economy, he concludes that "an important difficulty with further investigation is the limited macroeconomic data available on the effects of policy in recessions (or deep recessions)". Perhaps we need a few more Great Recessions in order to figure this out.

In another American Economic Association publication, the Journal of Economic Perspectives, Alan Auerbach, William Gale, and Benjamin Harris provide an extensive review of the variety in multiplier estimates, which they acknowledge is "embarrassingly large" after so many years of trying to measure it. Concerning the 2009 American Recovery and Reinvestment Act, though, they write, "If a fiscal stimulus were ever to be considered appropriate, the beginning of 2009 was such a time.… In these circumstances, our judgment is that a fiscal expansion carried much smaller risks than the lack of one would have".