21 May 2015 Show
When the economy is in bad shape, the effectiveness of increased government spending in boosting GDP depends on the depth of the recession. That is the central finding of new research by Giovanni Caggiano, Efrem Castelnuovo, Valentina Colombo and Gabriela Nodari. Their study, published in the May 2015 issue of the Economic Journal, finds that: · An increase in government spending is more effective exactly when it is most needed – that is, when the economy is experiencing a deep recession. · More precisely, the deeper the recession, the more output is generated by increasing government spending. According to the researchers'' estimates, one extra dollar spent by the US government during the recent Great Recession would have generated up to $2.50 in total national GDP in three years time. · Increasing government spending when economic conditions are less harsh generates positive effects on economic activity at most in the very short run: one extra dollar of government spending in milder recessions, like the one that followed the dot-com crisis in the early 2000s, would have generated less than $2 of GDP over three years. · Increasing government spending when the economy is in an expansionary period has mild positive effects at most for one year, but then would generate negative effects on output. The effectiveness of government spending in stimulating economic activity is a much-debated issue in economic policy. Academic researchers have found it challenging to quantify the gains from fiscal policy: what is the return from spending $1 of taxpayers'' money or ''how much bang for a buck?'' The new findings are at odds with the majority of work that has quantified the impact of fiscal spending on economic activity. This is due to two reasons that are often neglected. First, the researchers quantify the effects of government spending on output by taking account of the level of economic activity. While there are studies that distinguish between the effects of government spending in recessions and expansions, this research shows that what really matters is the depth of the recession: not all recessions are alike; and the effectiveness of fiscal spending increases when recessions are deep. Second, the new study takes account of the fact that any fiscal policy move takes time to be implemented. When a government recognises that the economy is in a recession and decides to intervene by increasing spending, in any democratic country it must first get the approval of Parliament and, after that approval, it must actually implement the stimulus package. This means that the increase in spending is observed in the official data several months after the public has come to know that spending is going to increase. But if today we anticipate that spending is going to increase, say, in one year, we are likely to take decisions immediately after the news, for example, by increasing investment and consumption, without waiting for the stimulus package to be actually implemented. If so, output would go up soon after the announcement of the increase in spending. Not taking account of the existence of this ''decision and implementation lag'' of fiscal policy, the duration of which in the United States is estimated to be on average two quarters, would lead to a severe underestimation of the impact of government spending on economic activity. The researchers conclude: ''While the policy implication of our research is clear – expansionary fiscal policy is highly effective when it is most needed – it comes with two ''buts''.'' ''First, it is based on the assumption that the debt level of the economy is sustainable. Hence, our findings do not imply a one-size-fits-all recommendation: increasing government spending is not a solution for countries whose level of debt might be perceived as unsustainable.'' ''Second, our results cannot be mirrored to cuts in fiscal spending: they do not imply that cutting fiscal spending is positive for output in expansions, nor negative when the economy is in recession.'' ''Estimating Fiscal Multipliers: News from a Nonlinear World'' by Giovanni Caggiano, Efrem Castelnuovo, Valentina Colombo and Gabriela Nodari is published in the May 2015 issue of the Economic Journal. Efrem Castelnuovo is at the University of Melbourne. Giovanni Caggiano and Valentina Colombo are at the University of Padua. Gabriela Nodari is at the University of New South Wales. Return to listing If you're seeing this message, it means we're having trouble loading external resources on our website. If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked. Chapter 30. Government Budgets and Fiscal Policy Learning ObjectivesBy the end of this section, you will be able to:
We need to emphasize that fiscal policy is the use of government spending and tax policy to alter the economy. Fiscal policy does not include all spending (such as the increase in spending that accompanies a war). Graphically, we see that fiscal policy, whether through change 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. Figure 1 illustrates the process by using an aggregate demand/aggregate supply diagram in a growing economy. 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.  Aggregate demand and aggregate supply do not always move neatly together. 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. 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 supply of money, 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 supply of money, 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 PolicyExpansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government 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 investments, 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 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. 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. Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of 2008–2009 (which started, actually, in very late 2007), U.S. government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009. 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 expansionary fiscal policy be implemented through spending increases. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy. 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. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one. Contractionary Fiscal PolicyFiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As shown in Figure 3, 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. This is sometimes known as 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. Again, the AD–AS model does not dictate how this contractionary fiscal policy is to be carried out. 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, aggregate demand needs to be reduced. Key Concepts and SummaryExpansionary 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
Review Questions
Critical Thinking Questions
ProblemsSpecify 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:
ReferencesAlesina, Alberto, and Francesco Giavazzi. Fiscal Policy after the Financial Crisis (National Bureau of Economic Research Conference Report). Chicago: University Of Chicago Press, 2013. Martin, Fernando M. “Fiscal Policy in the Great Recession and Lessons from the Past.” Federal Reserve Bank of St. Louis: Economic Synopses. no. 1 (2012). http://research.stlouisfed.org/publications/es/12/ES_2012-01-06.pdf. Bivens, Josh, Andrew Fieldhouse, and Heidi Shierholz. “From Free-fall to Stagnation: Five Years After the Start of the Great Recession, Extraordinary Policy Measures Are Still Needed, But Are Not Forthcoming.” Economic Policy Institute. Last modified February 14, 2013. http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/. Lucking, Brian, and Dan Wilson. Federal Reserve Bank of San Francisco, “FRBSF Economic Letter—U.S. Fiscal Policy: Headwind or Tailwind?” Last modified July 2, 2012. http://www.frbsf.org/economic-research/publications/economic-letter/2012/july/us-fiscal-policy/. Greenstone, Michael, and Adam Looney. Brookings. “The Role of Fiscal Stimulus in the Ongoing Recovery.” Last modified July 6, 2012. http://www.brookings.edu/blogs/jobs/posts/2012/07/06-jobs-greenstone-looney. Glossarycontractionary fiscal policyfiscal policy that decreases the level of aggregate demand, either through cuts in government spending or increases in taxesexpansionary fiscal policyfiscal policy that increases the level of aggregate demand, either through increases in government spending or cuts in taxesSolutionsAnswers to Self-Check Questions
What happens to fiscal policy during recession?During a recession, the government may lower tax rates or increase spending to encourage demand and spur economic activity. Conversely, to combat inflation, it may raise rates or cut spending to cool down the economy.
When should expansionary fiscal policy be used?Expansionary policy can consist of either monetary policy or fiscal policy (or a combination of the two). It is part of the general policy prescription of Keynesian economics, to be used during economic slowdowns and recessions in order to moderate the downside of economic cycles.
Which fiscal policy would be used to end a recession?expansionary fiscal policy
the use of fiscal policy to expand the economy by increasing aggregate demand, which leads to increased output, decreased unemployment, and a higher price level. Expansionary fiscal policy is used to fix recessions.
What is the fiscal policy action used to stimulate the economy during the recession?Expansionary fiscal policy, designed to stimulate the economy, is most often used during a recession, times of high unemployment or other low periods of the business cycle. It entails the government spending more money, lowering taxes or both.
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When the economy is in a recession the government can use expansionary fiscal policy?
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