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Principles of Economics 2e

30.6 Practical Problems with Discretionary Fiscal Policy

Principles of Economics 2e30.6 Practical Problems with Discretionary Fiscal Policy
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How To Organize Economies: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 Consumer Choices
    1. Introduction to Consumer Choices
    2. 6.1 Consumption Choices
    3. 6.2 How Changes in Income and Prices Affect Consumption Choices
    4. 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  8. 7 Production, Costs, and Industry Structure
    1. Introduction to Production, Costs, and Industry Structure
    2. 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
    3. 7.2 Production in the Short Run
    4. 7.3 Costs in the Short Run
    5. 7.4 Production in the Long Run
    6. 7.5 Costs in the Long Run
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  9. 8 Perfect Competition
    1. Introduction to Perfect Competition
    2. 8.1 Perfect Competition and Why It Matters
    3. 8.2 How Perfectly Competitive Firms Make Output Decisions
    4. 8.3 Entry and Exit Decisions in the Long Run
    5. 8.4 Efficiency in Perfectly Competitive Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Monopoly
    1. Introduction to a Monopoly
    2. 9.1 How Monopolies Form: Barriers to Entry
    3. 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  11. 10 Monopolistic Competition and Oligopoly
    1. Introduction to Monopolistic Competition and Oligopoly
    2. 10.1 Monopolistic Competition
    3. 10.2 Oligopoly
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  12. 11 Monopoly and Antitrust Policy
    1. Introduction to Monopoly and Antitrust Policy
    2. 11.1 Corporate Mergers
    3. 11.2 Regulating Anticompetitive Behavior
    4. 11.3 Regulating Natural Monopolies
    5. 11.4 The Great Deregulation Experiment
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  13. 12 Environmental Protection and Negative Externalities
    1. Introduction to Environmental Protection and Negative Externalities
    2. 12.1 The Economics of Pollution
    3. 12.2 Command-and-Control Regulation
    4. 12.3 Market-Oriented Environmental Tools
    5. 12.4 The Benefits and Costs of U.S. Environmental Laws
    6. 12.5 International Environmental Issues
    7. 12.6 The Tradeoff between Economic Output and Environmental Protection
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  14. 13 Positive Externalities and Public Goods
    1. Introduction to Positive Externalities and Public Goods
    2. 13.1 Why the Private Sector Underinvests in Innovation
    3. 13.2 How Governments Can Encourage Innovation
    4. 13.3 Public Goods
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Labor Markets and Income
    1. Introduction to Labor Markets and Income
    2. 14.1 The Theory of Labor Markets
    3. 14.2 Wages and Employment in an Imperfectly Competitive Labor Market
    4. 14.3 Market Power on the Supply Side of Labor Markets: Unions
    5. 14.4 Bilateral Monopoly
    6. 14.5 Employment Discrimination
    7. 14.6 Immigration
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
  16. 15 Poverty and Economic Inequality
    1. Introduction to Poverty and Economic Inequality
    2. 15.1 Drawing the Poverty Line
    3. 15.2 The Poverty Trap
    4. 15.3 The Safety Net
    5. 15.4 Income Inequality: Measurement and Causes
    6. 15.5 Government Policies to Reduce Income Inequality
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  17. 16 Information, Risk, and Insurance
    1. Introduction to Information, Risk, and Insurance
    2. 16.1 The Problem of Imperfect Information and Asymmetric Information
    3. 16.2 Insurance and Imperfect Information
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  18. 17 Financial Markets
    1. Introduction to Financial Markets
    2. 17.1 How Businesses Raise Financial Capital
    3. 17.2 How Households Supply Financial Capital
    4. 17.3 How to Accumulate Personal Wealth
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  19. 18 Public Economy
    1. Introduction to Public Economy
    2. 18.1 Voter Participation and Costs of Elections
    3. 18.2 Special Interest Politics
    4. 18.3 Flaws in the Democratic System of Government
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  20. 19 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 19.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 19.2 Adjusting Nominal Values to Real Values
    4. 19.3 Tracking Real GDP over Time
    5. 19.4 Comparing GDP among Countries
    6. 19.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 Economic Growth
    1. Introduction to Economic Growth
    2. 20.1 The Relatively Recent Arrival of Economic Growth
    3. 20.2 Labor Productivity and Economic Growth
    4. 20.3 Components of Economic Growth
    5. 20.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Unemployment
    1. Introduction to Unemployment
    2. 21.1 How Economists Define and Compute Unemployment Rate
    3. 21.2 Patterns of Unemployment
    4. 21.3 What Causes Changes in Unemployment over the Short Run
    5. 21.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  23. 22 Inflation
    1. Introduction to Inflation
    2. 22.1 Tracking Inflation
    3. 22.2 How to Measure Changes in the Cost of Living
    4. 22.3 How the U.S. and Other Countries Experience Inflation
    5. 22.4 The Confusion Over Inflation
    6. 22.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  24. 23 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 23.1 Measuring Trade Balances
    3. 23.2 Trade Balances in Historical and International Context
    4. 23.3 Trade Balances and Flows of Financial Capital
    5. 23.4 The National Saving and Investment Identity
    6. 23.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 23.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  25. 24 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Supply–Aggregate Demand Model
    2. 24.1 Macroeconomic Perspectives on Demand and Supply
    3. 24.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 24.3 Shifts in Aggregate Supply
    5. 24.4 Shifts in Aggregate Demand
    6. 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 24.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  26. 25 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 25.1 Aggregate Demand in Keynesian Analysis
    3. 25.2 The Building Blocks of Keynesian Analysis
    4. 25.3 The Phillips Curve
    5. 25.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  27. 26 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 26.1 The Building Blocks of Neoclassical Analysis
    3. 26.2 The Policy Implications of the Neoclassical Perspective
    4. 26.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  28. 27 Money and Banking
    1. Introduction to Money and Banking
    2. 27.1 Defining Money by Its Functions
    3. 27.2 Measuring Money: Currency, M1, and M2
    4. 27.3 The Role of Banks
    5. 27.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  29. 28 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 28.1 The Federal Reserve Banking System and Central Banks
    3. 28.2 Bank Regulation
    4. 28.3 How a Central Bank Executes Monetary Policy
    5. 28.4 Monetary Policy and Economic Outcomes
    6. 28.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  30. 29 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 29.1 How the Foreign Exchange Market Works
    3. 29.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 29.3 Macroeconomic Effects of Exchange Rates
    5. 29.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  31. 30 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 30.1 Government Spending
    3. 30.2 Taxation
    4. 30.3 Federal Deficits and the National Debt
    5. 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 30.5 Automatic Stabilizers
    7. 30.6 Practical Problems with Discretionary Fiscal Policy
    8. 30.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  32. 31 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 31.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 31.2 Fiscal Policy and the Trade Balance
    4. 31.3 How Government Borrowing Affects Private Saving
    5. 31.4 Fiscal Policy, Investment, and Economic Growth
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  33. 32 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 32.1 The Diversity of Countries and Economies across the World
    3. 32.2 Improving Countries’ Standards of Living
    4. 32.3 Causes of Unemployment around the World
    5. 32.4 Causes of Inflation in Various Countries and Regions
    6. 32.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  34. 33 International Trade
    1. Introduction to International Trade
    2. 33.1 Absolute and Comparative Advantage
    3. 33.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 33.3 Intra-industry Trade between Similar Economies
    5. 33.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  35. 34 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 34.3 Arguments in Support of Restricting Imports
    5. 34.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
    6. 34.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  36. A | The Use of Mathematics in Principles of Economics
  37. B | Indifference Curves
  38. C | Present Discounted Value
  39. D | The Expenditure-Output Model
  40. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
    22. Chapter 22
    23. Chapter 23
    24. Chapter 24
    25. Chapter 25
    26. Chapter 26
    27. Chapter 27
    28. Chapter 28
    29. Chapter 29
    30. Chapter 30
    31. Chapter 31
    32. Chapter 32
    33. Chapter 33
    34. Chapter 34
  41. References
  42. Index

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

  • Understand how fiscal policy and monetary policy are interconnected
  • Explain the three lag times that often occur when solving economic problems
  • Identify the legal and political challenges of responding to an economic problem

In the early 1960s, many leading economists believed that the problem of the business cycle, and the swings between cyclical unemployment and inflation, were a thing of the past. On the cover of its December 31, 1965, issue, Time magazine, then the premier news magazine in the United States, ran a picture of John Maynard Keynes, and the story inside identified Keynesian theories as “the prime influence on the world’s economies.” The article reported that policymakers have “used Keynesian principles not only to avoid the violent [business] cycles of prewar days but to produce phenomenal economic growth and to achieve remarkably stable prices.”

This happy consensus, however, did not last. The U.S. economy suffered one recession from December 1969 to November 1970, a deeper recession from November 1973 to March 1975, and then double-dip recessions from January to June 1980 and from July 1981 to November 1982. At various times, inflation and unemployment both soared. Clearly, the problems of macroeconomic policy had not been completely solved. As economists began to consider what had gone wrong, they identified a number of issues that make discretionary fiscal policy more difficult than it had seemed in the rosy optimism of the mid-1960s.

Fiscal Policy and Interest Rates

Because fiscal policy affects the quantity that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. In Figure 30.14, the original equilibrium (E0) in the financial capital market occurs at a quantity of $800 billion and an interest rate of 6%. However, an increase in government budget deficits shifts the demand for financial capital from D0 to D1. The new equilibrium (E1) occurs at a quantity of $900 billion and an interest rate of 7%.

A consensus estimate based on a number of studies is that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will cause an increase of 0.5–1.0% in the long-term interest rate.

The graph shows two demand curves that each intersect with a supply curve. Demand curve (D sub 0) intersects with supply curve (S) at E sub 0 (point $800, 6%). Demand curve (D sub 1) intersects with supply curve (S) at E sub 1 (point $900, 7%).
Figure 30.14 Fiscal Policy and Interest Rates When a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D0 to D1. As the equilibrium moves from E0 to E1, the equilibrium interest rate rises from 6% to 7% in this example. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.

A problem arises here. An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up less powerful than was originally expected. We refer to this as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

The broader lesson is that the government must coordinate fiscal and monetary policy. If expansionary fiscal policy is to work well, then the central bank can also reduce or keep short-term interest rates low. Conversely, monetary policy can also help to ensure that contractionary fiscal policy does not lead to a recession.

Long and Variable Time Lags

The government can change monetary policy several times each year, but it takes much longer to enact fiscal policy. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. Economists often call the time it takes to determine that a recession has occurred the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. Economists often refer to the time it takes to pass a bill as the legislative lag. Finally, once the government passes the bill it takes some time to disperse the funds to the appropriate agencies to implement the programs. Economists call the time it takes to start the projects the implementation lag.

Moreover, the exact level of fiscal policy that the government should implement is never completely clear. Should it increase the budget deficit by 0.5% of GDP? By 1% of GDP? By 2% of GDP? In an AD/AS diagram, it is straightforward to sketch an aggregate demand curve shifting to the potential GDP level of output. In the real world, we only know roughly, not precisely, the actual level of potential output, and exactly how a spending cut or tax increase will affect aggregate demand is always somewhat controversial. Also unknown is the state of the economy at any point in time. During the early days of the Obama administration, for example, no one knew the true extent of the economy's deficit. During the 2008-2009 financial crisis, the rapid collapse of the banking system and automotive sector made it difficult to assess how quickly the economy was collapsing.

Thus, it can take many months or even more than a year to begin an expansionary fiscal policy after a recession has started—and even then, uncertainty will remain over exactly how much to expand or contract taxes and spending. When politicians attempt to use countercyclical fiscal policy to fight recession or inflation, they run the risk of responding to the macroeconomic situation of two or three years ago, in a way that may be exactly wrong for the economy at that time. George P. Schultz, a professor of economics, former Secretary of the Treasury, and Director of the Office of Management and Budget, once wrote: “While the economist is accustomed to the concept of lags, the politician likes instant results. The tension comes because, as I have seen on many occasions, the economist’s lag is the politician’s nightmare.”

Temporary and Permanent Fiscal Policy

A temporary tax cut or spending increase will explicitly last only for a year or two, and then revert to its original level. A permanent tax cut or spending increase is expected to stay in place for the foreseeable future. The effect of temporary and permanent fiscal policies on aggregate demand can be very different. Consider how you would react if the government announced a tax cut that would last one year and then be repealed, in comparison with how you would react if the government announced a permanent tax cut. Most people and firms will react more strongly to a permanent policy change than a temporary one.

This fact creates an unavoidable difficulty for countercyclical fiscal policy. The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession, and then a contractionary fiscal policy with budget surpluses when the economy is growing well. However, if both policies are explicitly temporary ones, they will have a less powerful effect than a permanent policy.

Structural Economic Change Takes Time

When an economy recovers from a recession, it does not usually revert to its exact earlier shape. Instead, the economy's internal structure evolves and changes and this process can take time. For example, much of the economic growth of the mid-2000s was in the construction sector (especially of housing) and finance. However, when housing prices started falling in 2007 and the resulting financial crunch led into recession (as we discussed in Monetary Policy and Bank Regulation), both sectors contracted. The manufacturing sector of the U.S. economy has been losing jobs in recent years as well, under pressure from technological change and foreign competition. Many of the people who lost work from these sectors in the 2008-2009 Great Recession will never return to the same jobs in the same sectors of the economy. Instead, the economy will need to grow in new and different directions, as the following Clear It Up feature shows. Fiscal policy can increase overall demand, but the process of structural economic change—the expansion of a new set of industries and the movement of workers to those industries—inevitably takes time.

Clear It Up

Why do jobs vanish?

People can lose jobs for a variety of reasons: because of a recession, but also because of longer-run changes in the economy, such as new technology. Productivity improvements in auto manufacturing, for example, can reduce the number of workers needed, and eliminate these jobs in the long run. The internet has created jobs but also caused job loss, from travel agents to book store clerks. Many of these jobs may never come back. Short-run fiscal policy to reduce unemployment can create jobs, but it cannot replace jobs that will never return.

The Limitations of Fiscal Policy

Fiscal policy can help an economy that is producing below its potential GDP to expand aggregate demand so that it produces closer to potential GDP, thus lowering unemployment. However, fiscal policy cannot help an economy produce at an output level above potential GDP without causing inflation At this point, unemployment becomes so low that workers become scarce and wages rise rapidly.

Link It Up

Visit this website to read about how fiscal policies are affecting the recovery.

Political Realties and Discretionary Fiscal Policy

A final problem for discretionary fiscal policy arises out of the difficulties of explaining to politicians how countercyclical fiscal policy that runs against the tide of the business cycle should work. Some politicians have a gut-level belief that when the economy and tax revenues slow down, it is time to hunker down, pinch pennies, and trim expenses. Countercyclical policy, however, says that when the economy has slowed, it is time for the government to stimulate the economy, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. However, countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.

Politicians tend to prefer expansionary fiscal policy over contractionary policy. There is rarely a shortage of proposals for tax cuts and spending increases, especially during recessions. However, politicians are less willing to hear the message that in good economic times, they should propose tax increases and spending limits. In the economic upswing of the late 1990s and early 2000s, for example, the U.S. GDP grew rapidly. Estimates from respected government economic forecasters like the nonpartisan Congressional Budget Office and the Office of Management and Budget stated that the GDP was above potential GDP, and that unemployment rates were unsustainably low. However, no mainstream politician took the lead in saying that the booming economic times might be an appropriate time for spending cuts or tax increases. As of February 2017, President Trump has expressed plans to increase spending on national defense by 10% or $54 billion, increase infrastructure investment by $1 trillion, cut corporate and personal income taxes, all while maintaining the existing spending on Social Security and Medicare. The only way this math adds up is with a sizeable increase in the Federal budget deficit.

Discretionary Fiscal Policy: Summing Up

Expansionary fiscal policy can help to end recessions and contractionary fiscal policy can help to reduce inflation. Given the uncertainties over interest rate effects, time lags, temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers had concluded by the mid-1990s that discretionary fiscal policy was a blunt instrument, more like a club than a scalpel. It might still make sense to use it in extreme economic situations, like an especially deep or long recession. For less extreme situations, it was often preferable to let fiscal policy work through the automatic stabilizers and focus on monetary policy to steer short-term countercyclical efforts.

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