Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

Read this text, which offers a graphical depiction of how expansionary and contractionary fiscal policies shift aggregate demand.

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time, the quantity and quality of our resources grow as the population. Thus, the labor force gets larger as businesses invest in new capital and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure 17.10 illustrates.

The original equilibrium occurs at E0, the intersection of the aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) has an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now, the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

 Figure 17.10 A Healthy, Growing Economy In this well-functioning economy, each year aggregate supply and aggregate demand sh

Figure 17.10 A Healthy, Growing Economy In this well-functioning economy, each year, aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces a potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period, it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure 17.10 shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.

For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000 before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.

Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical – or "against the business cycle" – actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

Expansionary Fiscal Policy

Expansionary fiscal policy increases the level of aggregate demand through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes, (2) increasing investment spending by raising after-tax profits through cuts in business taxes, and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in Figure 17.11, which is similar to the U.S. economy during the 2007-2009 recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP, as the LRAS curve indicates. At the equilibrium (E0), a recession occurs, and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

 Figure 17.11 Expansionary Fiscal Policy The original equilibrium (E0) represents a recession, occurring at a quantity of out

Figure 17.11 Expansionary Fiscal Policy The original equilibrium (E0) represents a recession occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP that the LRAS curve shows. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.

Should the government use tax cuts, spending increases, or a mix of the two to carry out expansionary fiscal policy? During the 2007-2009 Great Recession, the U.S. economy suffered a 3.1% cumulative loss of GDP. That may not sound like much, but it's more than one year's average growth rate of GDP. Over that time frame, the unemployment rate doubled from 5% to 10%. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts. In contrast, liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending.

Events were even more severe during the more recent pandemic-induced recession. In a single quarter (Quarter 2 of 2020), GDP fell by over 9%, or at an annualized rate of about 34%. Policymakers were quick to respond with expanded unemployment insurance, aid to state and local governments (so that they didn't have to cut their spending as they did during the Great Recession), grants and tax breaks for small businesses, and perhaps most significantly, stimulus checks sent to over 100 million households, totaling thousands of dollars each. Since these were mostly spending measures, they were supported more by Democrats than by Republicans. However, both groups recognized the severity of the problem and were largely in agreement early on. Especially during the debates over later rounds of the stimulus checks, many discussions were had over the appropriate size and target of the checks. Ultimately, compromises were made, and no side got exactly what it wanted.

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as "liberal" or "conservative" or who want to use economic models to argue against their political opponents. However, advocates of smaller governments who seek to reduce taxes and government spending can use the AD-AS model, as well as advocates of bigger governments who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.

Contractionary Fiscal Policy

Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As Figure 17.12 shows, a very large budget deficit pushes up aggregate demand so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Economists sometimes call this an "overheating economy," where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.

 Figure 17.12 A Contractionary Fiscal Policy The economy starts at the equilibrium quantity of output Y0, which is above pote

Figure 17.12 A Contractionary Fiscal Policy The economy starts at the equilibrium quantity of output Y0, which is above the potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output, E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.

Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand.

Source: Rice University,
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Last modified: Thursday, September 21, 2023, 2:39 PM