fiscal

 

ESSAY (200-300 words): Briefly discuss the highlights of fiscal policy’s evolution in the United States over the last century

 Mc Eachem, W.A (2009). Econ for Macroeconomics. (2010-2011 ed, pp.174-179). Mason, OH: South-Western Pub

a federal deficit’ Note that
a contractionary fscalpolicy

nirrs to close an exPansionary
gaP’

The $hEuBtiBlBeE and
the Tfrme F{orfizsm

in the long run $ zero’

classical
econorrtiSts
a grsrrp ef 18th- an”-i
‘!Sti?-s*iltilrY ecs$-

n-?:5t3 wh* believeC fha

t

ee;:n*nriu d*wntursrs
t.jtl*ctct! th e?lt5s lves
thr*uqh natulal n’!arker
farces; thus.:it*Y
ileliev€d the eccn0lnV
was self-enrrecting anct

*eer!*ei no g*seri!rfi **1

!nterv*nt!at’t

The proper execution of cl -.-nr1r
;;;J”;6nary and contractlonal) ,
h?5;i;;1i;i;” assurnes that: .. , i=

11

e potenrial0utputisaccuratelygaugeq: ‘ ‘ , i*
8 the retevant spending.multiplier can be pred|cled

accuratery ; 2

I ‘ . aggregate demand can ne ifiitteO bt iusi
the right ayount –

t ?
‘ : ‘r r : ‘ I.’

cansomehilw coordinate
their i -Ho valisui glvemrnenLe*t!

‘
e)

‘:liseal.ei{otts-: ” : ,, i
o the shape 0f the short-run agsregate t’,Plll::ft

is known
:- ;;l;#.i-t unaffected bv the fiscal policv itsen’

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L03 Th* Evmiuti*r:
*f Fi*e s3 F*3ieY
bJow that yau have sorrle

idea of how fiscal po1*

icv can u’ork in th”;t’ let’s take. a
iaok at fiscal

IJtn” 1″‘ Jrr*,i.*, uugitt”i”g wich
the approach

Lsed-before the Great Depresston’

Pr’aor ts the Gneat SePressFern
Before the r93os, discretionary

fisca1 policy was se1-

dom used to l’-‘n’-t””t” th” ‘n”t’o”conomy’
Pubiic

;it.t-;; ,l’up”a uf-tr'” views.of ‘l'”tti:*
econo”

mists, who advoca’li’1o”tn’-Joire’
the beiief that

;;;”t*”;s were the best way to l+i”*
economlc

orosperity. ciassicat
“eco”o*ittt

did not deny that

Ltt:;t;;t; high unemplovment
occurred from

time to time, but tft”V'”tgi”i that
the sources of

such crises t”y ot”‘iiu th'” *”‘k”t :f5*’
in the

effectsofwars,taxincreases’poorgowingseasons’
changing tastes, “”;’;l;

like’ such external shocks

could reduc” o”tnt’i “^a “*pt”y*”ltl-b,tt
classical

economists u”rl”t'”a tT-‘”i tl-uC'”i
*utket forces’ such

as changes i” p’it”” *lg”t’ “”a
interest rates’ could

correct these Problems’
‘” “”‘*oiu oli ::lT :’;X\ ;TJ:TIIJ,f, :$ ;1 ?l i:
the economy’s Prrce I(

was produced, prices would
fall until the quantlty

]”*i’ff
”
;;;iil i]:”1r:\f ‘_i:Tli,* i: Y”-;;

H:: JT”lisi”li J#ffi: il;;’; ;t il’-“.: suppiied
:””;;;;ilqt'””titv a”*anded’ And

if the interest

;1″ ;;iigi’ t” ii*’i “u
that had been saved’

interest rates would;;ii;;iii the
amount invested

“q”uf”a
the amount saved’

So the classrcai upp’o”ttt
i*plied that natural mar-

ket forces, through fl’exible
prices’ wages) and inter-

est rates, would *o”” th” “to”o*y
toward potential

.rn the short run, the aggregate-
supp!

-curve
s10pes ;

upward, so a shift of ‘ffigui”
demand crha’rgtes tretJr

the price levei and tt-‘”e”1tti”r
of output’ wlen aggre-

#”?;”’ ;::”11″,:i,*,**tf;*X'”‘ff11 i
A*Tiru]”JilXl”ir;;;” “i”q”iiiu’ium

o”tpui in i
the short run depenas o”’tf'” stelpness

ofthe aggre- :

gui”,.,pprv..,*Iuj .x5*”::’j”ff:ilff”li*X i
;ff:*:;#:ffiffi;;;l”io*’upptv’u”n’

ih’ 1″”,
tmpacl a givenshrJt oJ ‘)”n

ois”S*” d’emand curvehas on i

real GDP andthe ^”‘i^i”‘li-ti.;*
*the price leuel’ so

i’tiu’
,iott , the spending multiplier’ -:.,^i-a irc nnrpn- i'”” ;;’;; *to*y ii already producrng

its poten- I

tial, then in the t”r ‘””‘-#:il::”t”:::”1’ff:T:tt:: i
:l?$”;;T’;;;ffic dema”d increases’

the p’ce

i#il#, “ot “nltt
output’ Thus’ if the economv

is already producingn’ fotnntiof’
the spending multiplier

i
i
:
?

i
i
t

!
t
t

:
i

The exact
change of

equilibrium
outPut in the

short run
depends on the
steePness of the
aggregate suPPlY

curve.

174 PART 3 f iricai atlti idorrerarY
PolrrrY

GDP. There appeared to be no need for government
intervention. What’s more, the government, like
househoids, was expected to live within its means.
The idea of govemment running a deficit was con-
sidered immoral. Thus, before the onset of the Great
Depression, most economists believed that discre-
tionary fiscal poliry could do more harm than good.
Besides, the federal government itself was a bit player
in the economy. At the onset of the Great Depression,
for exampie, federal outlays were less than 3 percent
of GDP (compared to about z4 percent today).

The Great ffiepressE##r
end ffifon&d War E$
Although classical economists acknowledged that
capitalistic, market-oriented economies could expe-
rience high unemployment from time to time, the
depth and duration of the depression strained belief
in the economy’s abiiity to mend itself. The Great
Depression was marked by four consecutive years of
contraction during which unempioyment reached z5
percent. Investment plunged 8o percent. Many facto-
ries sat idle. With vast unemployed resources, output
and income fell well short of the economy’s potential.

The stark contrast between the natural market
I adjustments predicted by classical economists and
! the years of high unemployment during the Great
g Depression represented a collision of theory and
$ fact. in 1936, John Maynard Keynes of Cambridge
H University, England, published The General Theory
I of Employment, Interest, and Money, a book that chal-
fr tenged the classical view and touched off what would
fr later be calied the Keynesian revolution. Keynesian
2 theory and palicy were developed in response to the prob-
), Iem of high unemployment during the Great Depression.
.’ Keynes’s main quarrel with the classical economists
5 was that prices and wages did not seem to be flexible
o enough to ensure the full employment of resources.

d
;t

‘l

According to Keynes, prices and wages were rela-
tively inflexible in the downward direction-they
were “sticky”-so natural market forces wouid not
return the economy to full employment in a timely
fashion. Keynes also believed business expectations
might at times become so grim that even very low
interest rates would not spur f,rms to invest all that
consumers might save.

It is said that geologists learn more about the
nature of the Earth’s crust from one major upheaval,
such as a huge earthquake or major volcanic erup-
tion, than from a dozen lesser events. Likewise,
economists learned more about the economy from
the Great Depression than from many more-modest
business cycles. Even though this depression began
about eight decades ago, economists continue to sift
through the rubble, looking for clues about how the
economy realiy works.

Three developments in the years following the
Great Depression bolstered the use of discretion-
ary fiscal poliry in the United States. The first was
the influence of Keynes’s General Theory, in which
he argued that natural forces would not necessariiy
close a contractionary gap. Keynes thought the econ-
omy could get stuck well below its potential, requir-
ing the government to increase aggregate demand to
boost output and employment. The second develop-
ment was the impact of World War II on output and
employment. The demands of war greatly increased
production and erased cyclical unemployment dur-
ing the war years, pulling the U.S. economy out of
its depression. The third development, Iargeiy a
consequence of the first two, was the passage of
the H;rrplayment A{t of :945, which gave the fed-
erai government responsibility for promoting full
employment and price stabiiity.

Prior to the Great Depression, the dominant fiscal
policy was a balanced budget. Indeed, to head off a
modest deficit in 1932, federal tax rates were raised,
which only deepened the depression. In the wake of
Keynes’s General Theory and World War II, however,
policy makers grew more receptive to the idea that
Sscal poliry could improve economic stability. The
objective of fiscal poliry was no longer to baiance the
budget but to promote full employment with price
stability even ifbudget deficits resulted.

Autematse
Stcb$Efreers

This chapter has focused
mostly on discretionary fis-
cal policy-conscious deci-
sions to change taxes and

Employment
Act of rga6
law that assigiled t{] the
federal govr:rn*reni the
responsibility for pro-
rnoting full eFlpl6yr”nent
ancl priee stability

C]{AFTIR r: ii:;cai Pclicir 175

government spending to achieve the economy’s
potential output. Now let’s get a clearer picture of
automatic stabilizers. Automatic stabilizers smooth
out JTuctuations in disposable income over the business
cycle by stimulating aggregate demand during recessions
and dampening aggregate demand during expansions.
Consider the federal income tax. For simplicity, we
have assumed that net taxes are independent of
income. In reality, the federal income tax system is
progressive, meaning that the fraction of income paid
in taxes increases as a taxpayer’s income increases’
During an economic expansion, employment and
incomes rise, moving some taxpayers into higher
tax brackets. As a result, taxes claim a growing frac-
tion of income. This slows the growth in disposabie
income and, hence, slows the growth in consumption.
Therefore, the progressive income tax relieves some
of the inflationary pressure that might otherwise
arise as output increases during an economic expan-
sion. Conversely, when the economy is in recession,
outpur dec.lirre-“, e-mploymenf and jncomes fal!. mov-

The Economy

Progressive
lncome Tax

Welfare
Benefits

176 PART 3 Frscel arrd lloneiary Pclrcv

ing some people into lower tax brackets. As a result,
taxes take a smaller bite out of income, so disposable
income does not fall as much as GDP. Thus, the pro-
gressive income tax cushions declines in disposable
income, in consumption, and in aggregate demand.

Another automatic stabilizer is unemployment
insurance. During economic expansions, the system
automatically increases the flow of unemployment
insurance taxes from the income stream into the
unemployment insurance fund, thereby moderating
consumption and aggegate demand. During con-
tractions, unempioyment increases and the system
reverses itself. Unemployment payments automati-
cally flow from the insurance fund to the unem-
ployed, increasing disposable income and propping
up consumption and aggregate demand. Likewise,
welfare payments automatically increase during
hard times as more people become eligible. Because
of these automatic stabilizers, GDP fluctuates less than
it otherwise would, and disposable income varies pro-
portionateiy less than does GDP. Because disposabie
income varies less than GDP does, consumption aiso
fluctuates less than GDP does.

The progressive income tax, unemploymentinsur-
ance, and welfare benefits were initially designed not
so much as automatic stabiiizers but as income redis-
tribution programs. Their roles as automatic stabilizers
were secondary effects of the legislation. Automatic
stabilizers do not eliminate economic fluctuations,
but they do reduce their magnitude. The stronger and
more effective the automatic stabilizers are, the iess
need for discretionary fiscal poliry’ Because of the
greater influence of automatic stabilizers, the economy
is more s tabie to d ay lh an it w as dur ing lhe Gr e at D epre s s ion

andbefore. As a measure of just how successful these
automatic stabilizers have become in cushioning the
impact of recessions, consider this: Between r948 and
zoo8, real GDP deciined during seven years, but real
consumption fell during only two years-by o.8 per-
cent in ry74andby o.3 percent in r98o. Real consump-
tion deciined in only two of the last 6o years. Without
much f anf are, qutomatic stabilizer s hav e b een quietly doing
their work,keeping the economy on a more evenkeeT.

Freirn the €olden
Age to Stagflation
The i96os was the Golden Age of fiscal poliry. )ohn F. .
Ketile{1 Nas $et\\s\presi{eltto praQsse a {ederal t-
budget defrcit to stimulate an economy experlenc- !
ing a contractionary gap. Fiscal policy was also used p

o\ occas\or\ to pro.rite a\ extra kick to arr expan- !
sion already under way, a$ in lg6+, when Kennedy’s $
successor, iyndon B. /ohnson, cut income tax rates 5
to keep an expansion alive. This tax cut, introduced to e

stimulqte business investment, consumption, and employ-
ment, was perhaps the shining example of fiscal policy dur-
ing the r96os. The tax cut seemed to work wonders,
increasing disposable income and consumption. The
unemployment rate dropped under 5 percent for the
first time in seven years, the inflation rate dipped
under 2 percent, and the federal budget deficit in
r964 equaled only o.9 percent of GDp (compared with
an average of 2.6 percent since i98o).

Discretionary fscal poliry is a demand-manq.gement
policy; the objective is to increase or decrease aggregate
demand to smooth economic fluctuations. Demand-
management policies were applied during much
of the r96os. But the r97os brought a different
probiem-stagflation, the doubie troubie of higher
inflation and higher unemployment resulting from
a decrease in aggregate supply. The aggregate sup-
p1y curve shifted left because of crop failures around
the world, sharply higher OpEC-driven oil prices, and
other adverse supply shocks. Demand-management
policies are ill suited to cure stagflation because an
increase of aggregate demand would increase infla-
tion, whereas a decrease of aggregate demand would
increase unemployment.

Other concerns also caused poliry makers and
economists to question the
effectiveness of discretionarv /

I

fiscai poiiry, These concern’s

*€
included the difficulty of esti-
mating the natural rate of
unempioyment, the time lags
involved in implementin

g

fiscal poliry, the distinction
between current income and
permanent income, and the
possible feedback effects of
fiscal policy on aggregate sup-
ply. We consider each in turn.

lixhibit 5
When Discretionary Fiscal Policy 0vershoots Potential 0utput

14.O 14.2 Real GDP
(trillions of dollars)

to AD’. In the short run, this stimulation of aggregate
demand expands output to $r4.2 trillion and reduces
unemployment to 4.o percent, so the poiiry appears
successful. But stimulating aggregate demand opens
up an expansionary gap, which in the long run results
in a leftward shift of the short-run aggregate supply
curve. This reduction in aggregate supply pushes up

140

o
o
o
‘3 130

Discretionary fi scal policy
is a demand-management

policy; the objective is
to increase or decrease

aggregate demand
to smooth economic

fluctuations.

prices and reduces real GDP
to $r+.o trillion, the economy’s
potential. Thus, poliry mak-
ers initially believe their plan
worked, but pushing produc-
tion beyond the economy’s
potential leads only to infla-
tion in the long run.

Fiscal Policy

.qL9..ig.tilis.q. “. ” “..
gg Given the effects of fiscal poi-

iry, particularly in the short
run, we should not be sur-

FHssafi F*63ep amc* €hs
ffi mtucwm $ ffimte #S q$*,n#mpFcxynerecru€

As we have seen, the unemployment that occurs when
the economy is producing its potential GDp is called
the naturs.l rate of unemployment. Before adopting discre_
tionary poiicies, public officials must coffectly estimate
this naturai rate. Suppose the economy is producing its
potential output of $r4.o triltion, as in Exhibit 5, where
the natural rate of unemployment is 5.o percent. Aiso
suppose that public officials mistakenly believe the
naturai rate to be 4.o percent, and they attempt to
reduce unemployment and increase real GDp through
discretionary fiscal poliry. As a result of their poliry, the
aggegate demand curve shifts to the right, from AD

prised that elected officials might try to use it to get
reelected. The link between economic performance
and reelection success has a long history. Ray Fair
of Yale University examined presidential elections
dating back to r9r6 and found, not surprisingly that
the state of the economy during the election year
affected the outcome. r Specifically, Fair found that
a declining unemployment rate and strong growth
rate in GDP per capita increased election prospects
for the incumbent party. Clearly, a weak economy
in zoo8 helped Barack Obama defeat the incumbent
party candidate, Iohn McCain.

‘1. Ray Fair Predicting Presidentlal Elections and 1ther Tltings (stanford,
Calif.; Stanford University Press, 2002).

g

Potential output

CHAPTER rp, i:iscalPaiic’t 777

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Another Yale economist,William Nordhaus, devel-

oped a theory of poiiiical bnciness eycles, arguing
that incumbent presidents, during an election year,
use expansionary policies to stimulate the economy,
often only temporarily. For example, evidence sug-
gests that President Nixon used expansionary policies
to increase his chances for reelection in 1972, even
pressuring the Federal Reserve chairman to pursue
an expansionary monetary policy.

The evidence to support the theory of political
business cycles is not entirely convincing. Read more
details about fiscal policy and elections in this chap-
ter’s case study on 4ltrpress.cengage.com,/econ.

fl-ags Ern FEseeE

The time required to approve and implement fiscal
legislation may hamper its effectiveness and weaken
discretionary fiscal poiiry as a tool of macroeconomic
stabiiization. Even if a fiscal prescription is appropri-
ate for the economy at the time it is proposed, the

months and sometimes years required to approve and

implement legislation means the medicine couid do
more harm than good. The policy might kick in oniy
after the economy has already turned itself around.
Because a recession is not usuaily identified until at

least six months after it begins,
and because the ro recessions
between 1945 and zoor lasted
only ro months on average,

discretionary fisca1 policY allows
little room for error (more later about
timing problems).

DiscretisffiaE”Se
FiseaB Fof;Eey end

Permam*ffi€ $ffi€effi?€
It was once believed that

discretionary fi scal pol-
icy couid be turned on
and off like a water
faucet, stimulating
or dampening the
economy at the
right time by just
the right amount.

Given the marginal

r.r ProPenslty to con-
1r i ,:r, sume, tax changesrl’. r could increase

,:t or decrease dis-
posable income
to bring about

desired change in consumption’ A more recent viev
suggests that people base their consumption deci
sions not mereiy on changes in their current incom’
but on changes in their permanent income.

P€rmanent incame is the income a persol
expects to receive on average over the long terrn
Changing tax rates does not affect consumptior
much if people view the changes as only temporarJ
In t967, for exampie, the escalating war in Vietnan
increased military spending, pushing real GDI
beyond its potential. The combination of a boom’
ing domestic economy and higher defense spending
opened up an expansionary gap by 1968. That year
Congress approved a temporary tax hike. The higher
tax rates were scheduied to last only 18 months
Higher taxes were supposed to soak up some dispos-
able income to reiieve inflationary pressure in the
economy. But the reduction in aggregate demand
turned out to be disappointingly smail, and inflation
was hardly affected. The temporary nature of the tax
increase meant that consumers faced only a smal)

cu r’Iir fieti *pretrrtatrYtn*rirtccnta Dkta’uss’Ite?rna1le{n*
income changed little, consumption changed little.
Consumers simply saved less. As another exampie,
in late t9g7,)apanese officials introduced an income
tax cut intended to stimulate Japan’s flat economy.
People expected the cut would be repealed after
a year, so economists were skeptical that the plan
would work, and it didn’t. Likewise, the stimulative
effects of the $6oo per family tax rebates in zoo8
were disappointing. In short, tothe extentthatconsum’
ers base spending decisions on their permanent income,
attempts to flne-tune the economy with temporary tax
changes are less efJective.

The Feedbask Hffeets cf Fiseal
Fofiiey #m Aggresate SUPPIY
So far we have limited the discussion of fiscal policy
to its effect on aggregate demand. Fiscal poiiry may
aiso affect aggegate supply, although this is usually
unintentionai. For exampie, suppose the government
increases unemployment benefits, paid with higher
taxes on earnings. If the marginal propensiry to con-
sume is the same for both groups, the increased
spending by beneficiaries just offsets the reduced
spending by workers. There would be no change in
aggregate demand and thus no change in equilib-
rium real GDP, simply a redistribution of disposabie
income from the employed to the unemployed.

But could the program affect labor supply? Higher
unempioyment benefits reduce the opportunity cost
of not working, so some job seekers may decide to
search at a more leisurely pace. Meanwhiie, higher
tax rates reduce the opportunity cost of leisure, so

PofrF*y

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nolitical business

ec$nomie fluet$a-
tioils ihat eccur rf’rhen
diselcti€fi ary policy is
n:*nipr:lated f*r politirai
gain

permanent income
i:tecme that individuais
expeet to re**is* sn
gverage cvsr the lili:E
term

17A PART 3 i:isrirl ;inc li’l*::r:taiv Polc-i

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