John Petroff's "Macroeconomics, Chapter 9: Fiscal Policy"

Read this chapter, which identifies fiscal policies governments use to combat inflation and recession. John Petroff provides information about government taxing and spending and prepares you to continue studying the role governments play in the macroeconomy.

The government spending increase section explains how policy makers use the government spending multiplier to calculate how to manipulate the economy to mitigate inflation or recession, beyond the ordinary uses of taxes. The multiplier calculates how much governments should increase or decrease spending to foster economic stability.

The tax increase section explains how policy makers use the tax multiplier to calculate how to manipulate the economy to mitigate inflation or recession, beyond the ordinary uses of taxes. The tax multiplier calculates how much governments should increase or decrease taxes to foster economic stability.

The balanced budget multiplier section explains how policy makers use the balanced budget multiplier to calculate how to reduce the budget deficit by collecting more taxes. This allows governments to match their revenue and expenses to create a balanced budget.

In this chapter, John Petroff discusses the benefits and limitations of the fiscal policies governments enact to discourage recession and inflation, and nondiscretionary fiscal policies.

Fiscal Policy

Fiscal policy describes how governments use taxes and spending to promote economic stability. For example, the U.S. Congress stated its fiscal intent when it passed the Employment Act of 1946 and the Humphrey-Hawkins Act of 1978.

In 1981, the U.S. Congress outlined a new taxation and spending policy to control the economy via the Economic Recovery Tax Act.


Government Spending Increase

Government spending is a component of aggregate expenditure. For example, the United States benefited from a multiplier effect when Franklin Delano Roosevelt convinced the U.S. Congress to pass his New Deal legislation, which included a series of funding programs, financial reforms, and regulations, to combat the national depression in 1933 and 1936. In a leakage-injection analysis, government spending is an injection that helps move the economy to a higher level of equilibrium.

Congress combined several major government-funded projects to create thousands of new jobs via the Tennessee Valley Authority in the 1930s. This new income individuals earned through these work projects and aggregate government expenditure provided a significant impetus to move the U.S. economy out of the great depression.


Tax Increase

Tax increases raise money for the government, but reduce the income of individuals and aggregate expenditure. If the tax increase is a lump sum tax, aggregate expenditure will move downward in a parallel fashion. A tax increase may be warranted when excessive consumer demand causes inflation. In the leakage-injection analysis, a tax increase is a leakage and is added to saving.

In the late 1960s, the U.S. congress enacted a tax surcharge to increase government revenue and decrease aggregate expenditure to reduce inflation. The taxes created a negative multiplier effect.


Balanced Budget Multiplier

The government budget is balanced when government spending equals the revenue it receives, such as from taxes. A balanced budget, that presents simultaneous increases in spending and taxes, is not neutral, but expansionary. The country experiences an increase in output because the additional spending outweighs the reductions in consumption and savings the tax increase may have caused. The value of the balanced budget multiplier is one.

During the early 1900s, most U.S. administrations felt the need to balance the federal budget. They matched spending increases with a corresponding increase in tax revenue. Until 1930, the economy grew at a healthy pace. However, in the 1930s, a balanced budget with reduced spending contracted rather than expanded the economy to exacerbate the recession.


Keynesian Fiscal Policy

John Meynard Keynes (1883-1946), the British economist, recommends governments employ expansionary fiscal policies (increase spending and reduce taxes) to combat a recession, and raise taxes and decrease spending to combat inflation.

Most Western governments adopt fiscal policies that use taxation and government spending to stabilize the economy, such when the U.S. Congress passed the Employment Act of 1946.


Fiscal Policy Effectiveness

Expansionary fiscal policy—when governments borrow money to finance spending rather than raise taxes or print new money—may be less effective than what is necessary if a crowding-out effect occurs. Policies that fight inflation via reduced spending and increased taxation may also be ineffective if governments use the budget surplus to repay debt rather than to stimulate the economy.

The tax surcharge congress enacted to combat inflation in the late 1960s did not effectively stop inflation because the government immediately spent the revenues it collected on the Vietnam war effort.


Crowding-Out Effect

A crowding-out effect occurs when governments borrow money—private investment is curtailed because investors prefer to lend their money to the federal government (which offers a guaranteed rate of return) rather than to private borrowers who tend to be more risky. Consequently, private investment falls.

Interest rates in the United States were higher than in other Western nations from 1970 to 1980 because the government needed to refinance its expanding public debt. The U.S. Treasury offered a high rate of return (interest rate) to investors to encourage them to buy government bonds and other financial issues. Many economists blame these high interest rates for slowing economic growth during this period.


Fiscal Policy Lags

Various delays may reduce the effectiveness of fiscal policy. Governments experience a recognition lag when leaders fail to readily identify the cause of a problem. They experience an administrative lag when leaders fail to readily enact an appropriate statute to respond to a problem. They experience an operational lag when leaders fail to readily realize the effect of tax changes.

When John Kennedy became president in 1960, he immediately proposed a tax cut to alleviate a mild economic slow down, in accordance with Keynesian fiscal policy. However, since Congress did not enact the tax cut until 1964, the country did not feel its effects until several years later when the U.S. economy was beginning to experience inflation and needed a different fiscal policy.


NonDiscretionary Fiscal Policy

Nondiscretionary fiscal policy refers to various ongoing government spending and taxation programs Congress enacted to maintain government financial stability. These programs include social security, welfare, and unemployment compensation.

Unemployment benefits present a typical example of nondiscretionary fiscal policy. The payments increase when the number of unemployed workers increases during an economic slow down. The payments decrease when unemployed workers return to work during an economic recovery.


Automatic Stabilizer

Nondiscretionary fiscal policy serves as an automatic stabilizer in the economy because government payments tend to increase when the economy is in recession, and the collection of government contributions (taxes) decreases due to lower aggregate income. When the economy prospers, government payments decrease and tax collections increase. The surplus in prosperity and deficit in recession correlates with fiscal policies that are needed to alleviate (but not entirely correct) a negative economic condition.

The largest unemployment benefits are paid out when unemployment is the highest. Consequently, the benefits offset the decreasing income from out-of-work workers. But the benefits are only a small portion of the income foregone—it is only a partial corrective measure.


Full-Employment Budget

Since the automatic stabilizer of nondiscretionary fiscal policy we just described creates insufficient deficits and surpluses, governments must determine how much additional policy action they need to provide to help stabilize the economy. Governments use the full employment budget, what the budget surplus or deficit would have been if the economy had been at full employment, to help calculate the appropriate amount.

From 1970 to 1980, the American budget was in deficit. Due to high rates of unemployment during this time, the full-employment budget was in surplus—if the unemployed workers had worked during these years, the taxes they would have paid would have been larger than the spending. Consequently, government officials could have justified spending more government money to get the unemployed workers working, despite creating greater budget deficits.


Fiscal Drag

The automatic stabilizer of nondiscretionary fiscal policy creates surpluses during periods of prosperity. These surpluses may impede or create a drag on further economic growth.

Congress enacted social security as part of the New Deal. At that time, few retirees were eligible to receive the social security payments. Since contributions were drawn on all salaries, the extra social security payments people contributed prevented the economy from recovering more quickly from the great depression.


Budget Deficit

Budget deficits occur when government spending exceeds government revenues. During the 1970s and 80s, the U.S. federal budget has been in deficit every year except one. These deficits result from Keynesian expansionary fiscal policies. However, the tax cuts President Ronald Reagan imposed during the 1980s, inspired by supply side economics policies, caused the deficits to grow even larger. Reducing budget deficits became a political priority when the U.S. Congress passed the Gramm-Rudman-Hollings Act in 1985.

Budget Philosophy

The belief that governments need to balance the budget annually is unpopular because it is procyclical—it tends to magnify business cycles. However, critics argue that a functional budget philosophy, which tolerates deficits when needed according to Keynesian employment theory, creates excessive debt. A cyclically-balanced budget philosophy presents an a third alternative.

Americans learned about the most devastating effects of a balanced budget philosophy when President Herbert Hoover's administration tried to balance the budget in the early 1930s. Great Britain had a similar experience. The government spending cuts contributed significantly to the severity of the great depression.


Public Debt

The continuous budget deficits of the 1970s and 1980s created a large public debt that exceeded $2 trillion in early 1990. Economists argue whether the debt will negatively affect the economy, such as through the crowding-out-effect and eventual need to repay the debt with interest. Governments not only need to repay the debts they incur with interest, but the fact that the United States owes so much money to foreign countries could devalue the U.S. dollar in the currency exchange market.

Economists attribute the stock market crash of Oct. 19, 1987 to the large public debt the U.S. government has incurred. Inflation increased when the government was forced to offer investors a high interest rates to refinance the public debt. These high interest rates decreased the value of government financial assets and prompted investors to sell, which drove the price of the dollar down further.


Fiscal Policy and Politics

In democracies, the elected officials who enact fiscal policies frequently prioritize national security, the provision of public goods and services, redistribution of income, and other spending initiatives over economic stability. Unfortunately, many elected officials are more concerned with getting reelected than maintaining economic stability.

Fiscal Policy and Politics

Politicians often implement expansionary fiscal policies, through tax cuts and increased government spending, before elections to create favorable economic indicators. Since these fiscal policies tend to increase inflation and the budget deficit, a contractionary fiscal policy is often needed soon after elections are over.

Net Export Effect

The net export effect reduces the effectiveness of fiscal policy. When governments implement an expansionary fiscal policy, net exports usually decline, which decreases aggregate output. This decrease in aggregate output partially offsets the expansionary fiscal policy.

When governments implement a contractionary fiscal policy, net exports usually increase. This increase in aggregate output partially offsets the contractionary fiscal policy.

Index of Leading Indicators

Economists use the U.S. Index of Leading Indicators to eliminate or shorten recognition lags. While none of these indicators can predict the course the economy will take with certainty, they usually provide a good idea for where the economy is headed. Economists average or index the 11 leading indicators to provide a comprehensive forecast. When the Index of Leading Indicators declines or increases for three consecutive months, economists can usually predict the economy is moving in a particular direction.

Last modified: Friday, December 14, 2018, 10:39 AM