Robert J. Stonebraker, Winthrop University
The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop
University
Spending and Tax Policy
The chief business of the American people is
business.
...Calvin Coolidge
Aggregate demand (AD) in the economy grows over time, but it rarely grows at exactly the same rate as aggregate supply (AS). Changes in AD generally are more erratic, or more cyclical, than changes in AS. Cyclical downturns in AD create recessions and unemployment. Cyclical booms in AD often result in inflation. More steady and controlled increases in AD might eliminate much of the cyclical instability that plagues economic growth.
Macroeconomists historically argued that cyclical swings were best left alone. Such swings are inevitable and eventually cure themselves anyway. If AD zooms up too quickly, the resulting inflation will eventually choke off excess demand and bring the process to a halt. If demand drops and throws workers out on the streets, wages will eventually fall far enough to give firms the incentive to rehire the workers and return us to full employment.
Keynes and fine-tuning AD
The Great Depression of the 1930’s blew this consensus out of the water. British economist John Maynard Keynes led a cadre of young economists who argued that discretionary government policy could cure and prevent cyclical instabilities. Is AD too low? Is unemployment building up? If so, have the government raise demand and restore full employment. Is AD too high? If so, have government lower AD and wring any inflationary pressure out of the economy quickly. By fine-tuning AD so that it always keeps exact pace with AS, government policy-makers could relegate our cyclical bouts with unemployment and inflation to the dusty pages of ancient history.
Political liberals who favored more government involvement in the economy quickly championed this new Keynesian economics. Although conservative free-market proponents who distrusted government did their best to ignore Keynes and his ideas altogether, even Republican President Richard Nixon admitted in the 1970’s that “we are all Keynesians now.”
Alas. The promise of fine-tuning proved more elusive than early Keynesian proponents predicted. Government manipulation of AD proved to be far more difficult in practice than in theory. No serious modern macroeconomist believes that cycles can so easily be cured. Nonetheless, the basic notion that government policy makers might moderate or ease the more severe cycles remains firmly entrenched among most members of the profession.
Discretionary fiscal policy
How can the government impact AD? Fiscal policy offers one possible avenue.
Do you remember the four categories of aggregate demand? They were consumption (C), investment (I), government spending on goods and services (G), and net foreign demand (F). Government clearly controls G and, by changing taxes, can impact C easily as well.
Suppose that the economy has plunged into a recession with high rates of unemployment. An increase in AD could create new spending, jobs and income and help us regain full employment. Government has two obvious approaches to this.
1. Increase government spending. New G directly raises demand for the goods and services purchased. More spending on military aircraft means new jobs and incomes for defense contractors, employees and suppliers. More spending on highways means new jobs and income for road contractors, suppliers and engineers. Such spending can indirectly benefit other as well. Suppose the Department of Defense orders new military blankets from a local textile firm that, in turn, hires previously laid-off employees to complete the work. The newly hired employees clearly benefit, but they are not alone. As they spend their new income in the local groceries and movie theaters and restaurants and malls, these businesses benefit as well. The initial government dollars create ripple effects or multiplier effects as they flow through other firms and are spent over and over again.
2. Decrease taxes. If government slashes your tax bill by $100, how will you react? Will you spend all or most of the $100? Most of us will. Tax cuts put additional dollars in our wallets and increase our consumption. This new consumption, in turn, creates new demands, new jobs and new incomes -- complete with ripple or multiplier effects -- through the economy.
Although increased government spending and/or decreased taxes can help pull an economy out of a recession, they do not promise the proverbial free lunch. Caution is always advised. For example, if the economy is already operating at or near full employment, the increased G and/or C will have little or no impact on real income or production. In a fully-employed economy we cannot produce more of one thing without producing less of something else. In these cases, resources needed to support new government or consumer demands must be taken away from other sectors of the economy. For example, suppose the government awards an extra $100 billion in defense contracts to Boeing. If Boeing has no excess capacity and cannot find new workers, it can increase its defense production only by cutting its production of aircraft for the private sector. The new spending and production for government contracts simply crowds out spending and production for other private markets. Fiscal policy can raise real output and cure a recession only if it can mobilize resources that otherwise would have been unemployed and idle.
To cure inflation, the appropriate fiscal policies reverse: decrease government spending and/or increase taxes. Both should cut overall AD: the former by cutting G and the latter by taking additional dollars from taxpayers who, in turn, will decrease C. The drop in AD should wring out any inflationary pressure and stabilize prices.
Government budget balances
We have assumed that government budgets need not always be in balance. The expansionary fiscal policies of more spending and/or less taxation might help in fighting a recession, but both will push government budgets into a deficit. The contractionary policies of less spending and/or more tax used to fight inflation tend to create a surplus in government accounts. Is this a problem? Not necessarily.
First, the U.S. Constitution does not mandate a balanced budget. Budget deficits and budget surpluses are perfectly legal at the federal level.1 If the U.S. Congress wants to spend $100 more than it has in tax revenues, it empowers the Department of the Treasury to borrow the $100 by issuing or selling $100 of government bonds. The bonds basically are a contract in which the government promises to repay the $100 plus interest after some specified period of time. In other words, federal budget deficits are financed by borrowing or by going into debt. Similarly, government surpluses can be used to retire or pay off any debt.
Theoretically, governments could run deficits to stimulate new demand during lean economic years and then run surpluses to cool off demand and inflation during boom periods. Any debts accumulated during recessions could be wiped off the books by running surpluses during booms. However, for a variety of reasons, most governments have accumulated substantial debts by running far more deficits than surpluses -- a controversial practice examined in another reading.
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Notes:
1. Most state constitutions require a balanced budget for current operations, but allow legislatures to borrow to finance long-term capital projects.
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Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:
1. Explain how fiscal policy can be used to counter problems of inflation and unemployment.
2. Explain why initial changes in aggregate demand might create multiplier effects.
3. Explain why expansionary fiscal policy can raise output only during a recession with unemployed or idle resources.
4. Explain the impacts of discretionary fiscal policy on government budgets.
5. Explain how the government can spend more than it receives in taxes.