17.4Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

front edge of the baby boom generation reached age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. During the 2020 recession, we saw another wave of early retirements, and we are now in the middle of this major demographic shift. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for increasingly large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast. CLEAR IT UP What is the long-term budget outlook for Social Security and Medicare? In 1946, just one American in 13 was over age 65. By 2000, it was one in eight. By 2030, one American in five will be over age 65. Two enormous U.S. federal programs focus on the elderly—Social Security and Medicare. The growing numbers of elderly Americans will increase spending on these programs, as well as on Medicaid. The current payroll tax levied on workers, which supports all of Social Security and the hospitalization insurance part of Medicare, will not be enough to cover the expected costs, so what are the options? Long-term projections from the Congressional Budget Office in 2021 are that Medicare and Social Security spending combined will rise from 8.7% of GDP in 2021 to about 10.8% by 2027–2031. If this rise in spending occurs, without any corresponding rise in tax collections, then some mix of changes must occur: (1) taxes will need to increase dramatically; (2) other spending will need to be cut dramatically; (3) the retirement age and/or age receiving Medicare benefits will need to increase, or (4) the federal government will need to run extremely large budget deficits. Some proposals suggest removing the cap on wages subject to the payroll tax, so that those with very high incomes would have to pay the tax on the entire amount of their wages. Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare. The United States is not alone in this problem. Providing the promised level of retirement and health benefits to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan. How to pay promised levels of benefits to the elderly will be a difficult public policy decision. In the next module we shift to the use of fiscal policy to counteract business cycle fluctuations. In addition, we will explore proposals requiring a balanced budget—that is, for government spending and taxes to be equal each year. The Impacts of Government Borrowing will also cover how fiscal policy and government borrowing will affect national saving—and thus affect economic growth and trade imbalances.

17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

LEARNING OBJECTIVES By the end of this section, you will be able to:

• 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 17.10 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.

FIGURE 17.10A 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. 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 17.11Expansionary 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 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, 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. 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 like 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, although 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 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 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 17.12A 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.

17.5 Automatic Stabilizers

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Describe how the federal government can use discretionary fiscal policy to stabilize the economy
• Identify examples of automatic stabilizers
• Understand how a government can use standardized employment budget to identify automatic stabilizers

In 2020, more than 20 million people could collect unemployment insurance benefits to replace some of their salaries. Federal fiscal policies include discretionary fiscal policy, when the government passes a new law that explicitly changes tax or spending levels. The 2020 stimulus checks and increases in state and local government aid are an example. Changes in tax and spending levels can also occur automatically, due to automatic stabilizers, such as unemployment insurance and food stamps, which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially inflationary boom.

Counterbalancing Recession and Boom

Consider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be a dose of contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net. The process works in reverse, too. If aggregate demand were to fall sharply so that a recession occurs, then the prescription would be for expansionary fiscal policy—some mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance. In addition, the automatic stabilizers react to a weakening of aggregate demand with expansionary fiscal policy and react to a strengthening of aggregate demand with contractionary fiscal policy, just as the AD/AS analysis suggests. A combination of automatic stabilizers and discretionary fiscal policy produced the very large budget deficit in 2020. The pandemic caused high levels of unemployment, meaning less tax-generating economic activity. The high unemployment rate triggered the automatic stabilizers that reduce taxes and increase spending, due to the increased amount of unemployment insurance paid out by the federal and state governments. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession. A glance back at economic history provides a second illustration of the power of automatic stabilizers.

Simpler explanation — Cambridge AS & A Level Economics

Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to achieve the government’s macroeconomic aims. The government’s annual budget is a statement of its fiscal policy. The budget often receives much media attention as it is an indicator of both fiscal policy intentions and economic performance. In the budget statement, the finance minister outlines the government’s spending and taxation plans for the year ahead. A budget surplus arises when tax revenue exceeds government spending.

In contrast, a budget deficit occurs when government spending exceeds tax revenue and a balanced budget is when government spending matches tax revenue. Most governments seek to achieve a balanced budget over time. In the short term, a government may aim for, or welcome, a budget deficit if there is a low level of economic activity. A budget deficit may occur in this situation as a result of both deliberate government action and of automatic stabilisers. If there is a decline in economic growth and a rise in unemployment, a government may decide to cut tax rates and increase government spending.

It may also allow government spending on unemployment benefits to rise and tax revenue to fall as an automatic result of a slowdown in the economy. A budget deficit that occurs due to a fall in economic activity is known as a cyclical deficit. A government is unlikely to be concerned about a cyclical deficit as it will move towards a balance as economic activity increases. However, a government will be concerned about a structural deficit. A structural deficit arises when a government is committed to too much spending relative to its tax revenue.