Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

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Fiscal policy

*Explain how expansionary fiscal policy can shift aggregate demand and influence the economy

*Explain how contractionary fiscal policy can shift aggregate demand and influence the economy

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 and thus the labor force get 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) illustrates.

The original equilibrium occurs at E₀, the intersection of 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) is 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.

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 at 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.

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), which is similar to the U.S. economy during the 2008-2009 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.

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 which 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 or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the 2008-2009 Great Recession (which started, actually, in late 2007), 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 consensus view is that this was possibly the worst economic downturn in U.S. history since the 1930’s Great Depression. 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, while 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.

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 government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, 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) 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.

A Contractionary Fiscal Policy

The economy starts at the equilibrium quantity of output Y₀, which is above 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.

Key Concepts and Summary

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.

Self-Check Questions

What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?

To keep prices from rising too much or too rapidly.

What is the main reason for employing expansionary fiscal policy during a recession?

To increase employment.

Review Questions

What is the difference between expansionary fiscal policy and contractionary fiscal policy?

Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy?

Critical Thinking Questions

How will cuts in state budget spending affect federal expansionary policy?

Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer.

Problems

Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:

1. A recession.
2. A stock market collapse that hurts consumer and business confidence.
3. Extremely rapid growth of exports.
4. Rising inflation.
5. A rise in the natural rate of unemployment.
6. A rise in oil prices.

dikutip dari  OpenStax – Principles of Economics

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