A Bit of History

• The potential for the use of fiscal policy emerged during the Great Depression of the 1930s. As this decade of stagnation unfolded, attention was focused on the demand side of the economy, both as the cause the problems and the potential solution.


• This attention gained an enormous boost with publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936. This book launched Keynesian economics and the modern study of macroeconomics. Keynesian economics theoretically emphasized the importance of aggregate expenditures to business-cycle instability, especially the devastation of the Great Depression, and then pointed to the use of fiscal policy as the appropriate correction.


• Keynesian economics dominated the study of macroeconomics and government policies for the ensuing four decades. During this period, fiscal policy became increasingly important. It was the principal stabilization policy tool used in the 1960s and early 1970s. A noted fiscal policy tax cut was implemented under the Kennedy/Johnson Administrations to stimulate the economy, and stimulation is what occurred. A fiscal policy tax increase was enacted during the Nixon Administration during the 1970s to combat inflation, with lesser success.


• Even though Keynesian economics fell out of favor in the 1980s with monetary policy (the use of the money supply to control business cycles) becoming the stabilization policy of choice, fiscal policy continued to play a key role in the economy -- either by design or by default. By default, the Reagan Administration during the 1980s, cut taxes and increased spending, the fiscal policy recipe for an expanding economy, which subsequently occurred. By design, the second Bush Administration during the early 2000s cut taxes for the purported goal of stimulating the economy, another act of fiscal policy, also with lesser success.

Policy Tools

• Government Purchases: These are the expenditures by the government sector, especially the federal government, on final goods and services. They are the portion of gross domestic product purchased by the government sector. Any change in government purchases, as such, directly affects aggregate expenditures and thus the macroeconomy.


• Taxes: These are involuntary payments from the household sector to the government sector. Taxes are the primary source of revenue used by government to finance government spending. Taxes affect the amount of disposable income available for consumption and saving. As such, any change in taxes indirectly affects aggregate expenditures and the macroeconomy through consumption expenditures and investment expenditures (via saving).


• Transfer Payments: These are gifts made to the household sector. Unlike government purchases, these payments are not made in exchange for goods and services. Because these are financed with taxes, transfer payments are, in effect, the transfer of income from one person to another. Because transfer payments also affect the amount of disposable income available, any change in transfer payments also as an indirect effect on aggregate expenditures.

Expansionary and Contractionary

• Expansionary Fiscal Policy: The recommended fiscal policy to correct the problems of a business-cycle contraction is expansionary fiscal policy. Expansionary fiscal policy includes any combination of an increase government purchases, a decrease in taxes, or an increase in transfer payments. This fiscal policy alternative is intended to stimulate the economy by increasing aggregate expenditures and aggregate demand. It is primarily aimed at reducing unemployment.


• Contractionary Fiscal Policy: The recommended fiscal policy to correct the inflationary problems of a business-cycle expansion is contractionary fiscal policy. Contractionary fiscal policy includes any combination of a decrease government purchases, an increase in taxes, or a decrease in transfer payments. This fiscal policy alternative is intended to restrain the economy by decreasing aggregate expenditures and aggregate demand. It is primarily aimed at reducing inflation.

A Budgetary Word

In particular, fiscal policy, especially that undertaken by the federal government, is commonly evaluated in terms of budget deficits and surpluses.

• With expansionary fiscal policy--through an increase in government spending, either purchases or transfer payments, or a decrease in taxes--then the budget moves in the direction of a deficit or at the very least a smaller surplus.


• With contractionary fiscal policy--through a decrease in government spending, either purchases or transfer payments, or an increase in taxes--then the budget moves in the direction of a surplus or at the very least a smaller deficit.

Full Employment Gaps

• Recessionary Gap: A recessionary gap exists if the existing level of aggregate production is less than what would be produced with the full employment of resources. This gap arises during a business-cycle contraction and typically gives rise to higher rates of unemployment.


• Inflationary Gap: An inflationary gap exists if the existing level of aggregate production is greater than what would be produced with the full employment of resources. This gap typically arises during the latter stages a business-cycle expansion and typically gives rise to higher rates of inflation.

Full Employment Gaps

The positively-sloped short-run aggregate supply curve is labeled SRAS. Short-run equilibrium in the aggregate market occurs at the price level and real production corresponding to the intersection of the aggregate demand curve and this SRAS curve. Should short-run real production fall short of full-employment real production, then a recessionary gap results. Should it exceed full-employment real production, then an inflationary gap arises. However, to identify either gap an aggregate demand curve needs to be added to the graph.

• Less Than Full Employment: To include an aggregate demand curve that generates a recessionary gap for this aggregate market, click the [Recessionary Gap] button. Doing so reveals a short-run equilibrium level of real production that is less than full employment, which is a recessionary situation. Note that the aggregate demand curve intersects the SRAS curve at a real production level to the left of the LRAS curve. This means the short-run real production is less than full-employment real production. The difference between short-run equilibrium real production and full-employment real production is the recessionary gap.


• Greater Than Full Employment: To include an aggregate demand curve that generates an inflationary gap for this aggregate market, click the [Inflationary Gap] button. Doing so reveals a short-run equilibrium level of real production that is greater than full employment, which is an inflationary situation. Note that the aggregate demand curve now intersects the SRAS curve at a real production level to the right of the LRAS curve. This means the short-run real production is greater than full-employment real production. The difference between short-run equilibrium real production and full-employment real production is the inflationary gap.

Closing the Gaps

Recessionary Gap
Inflationary Gap

To illustrate how this occurs, consider the exhibit to the right. The top panel presents a recessionary gap and the bottom panel an inflationary gap.

• Stimulation: The recessionary gap can be closed with expansionary fiscal policy--an increase in government purchases, a decrease in taxes, or an increase in transfer payments. This policy shifts the aggregate demand curve to the right and closes the gap. To illustrate how this works, click the [Expansionary Policy] button. If done correctly, the aggregate demand curve intersects the short-run aggregate supply curve at the full employment level of aggregate production indicated by the long-run aggregate supply curve.


• Restraint: The inflationary gap can be closed with contractionary fiscal policy--a decrease in government purchases, an increase in taxes, or a decrease in transfer payments. This policy shifts the aggregate demand curve to the left and closes the gap. To illustrate how this works, click the [Contractionary Policy] button. If done correctly, the aggregate demand curve also intersects the short-run aggregate supply curve at the full employment level of aggregate production and the long-run aggregate supply curve.

Policy Lags

Four types of policy lags are common.

• Recognition Lag: This is the time it takes to identify the existence of a problem. It takes time to obtain economic measurements. Once data are obtained, it takes time to analyze and evaluate the data to document the problem.


• Decision Lag: This is the time it takes to decide on a suitable course of action, then pass whatever legislation, laws, or administrative rules are needed. For fiscal policy, this requires an act of Congress, signed into law by the President. These decisions could take days, weeks, or even months.


• Implementation Lag: This is the time it takes to implement the chosen policy. A spending change requires actions by dozens, hundreds, or even thousands of different government agencies, all of which need to decide on to change their budgets. A tax change requires the distribution of new tax rates and responses by those paying the taxes. The implementation of fiscal policy is also likely to take weeks if not months.


• Impact Lag: This lag is the time it takes any change initiated by a government policy to actually impact the producers and consumers in the economy. A key part of the impact lag is the multiplier. A change in government spending or taxes must work its way through the economy, triggering subsequent changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption. An impact lag of one to two years is not uncommon.

Automatic Stabilizers

This mechanism is termed automatic stabilizers. Automatic stabilizers are taxes and transfer payments that depend on the level of aggregate production and income such that they automatically dampen business-cycle instability without the need for discretionary policy action.

Automatic stabilizers work AUTOMATICALLY. There is no need for Congress or the President to enact legislation, pass bills, or to undertake any other policy action. These stabilizers are built into the structure of the economy. The government sets up the rules and criteria under which taxes and transfer payments work. If people meet the criteria, then they pay the taxes or receive the transfer payments. The amount of each depends on the number of people meeting the criteria, which is dependent on business cycle activity.

Let's take a closer look at each of the two automatic stabilizers -- taxes and transfer payments.

• Taxes: Income taxes, especially federal income taxes, largely depend on the level of aggregate production and income in the economy. If production and income rise, then tax collections also rise. Income taxes also tend to be progressive -- the proportion of taxes paid increases with income.

  As such, people pay an increasing proportion of income in taxes when the economy expands, leaving proportionally less disposable income available for consumption expenditures and further expansionary stimulation. Moreover, people pay a decreasing proportion of income in taxes when the economy contracts, leaving proportionally more disposable income available for consumption expenditures.



• Transfer Payments Transfer payments, including Social Security to the elderly, unemployment compensation to the unemployed, and welfare to the poor, also depend on the level of aggregate production and income. These, however, work opposite to taxes. If aggregate income rises, transfer payments tend to fall as people are less likely to retire, be unemployed, or fall into the ranks of the poor.

  As the economy expands, and aggregate income increases, people receive increasingly fewer transfer payments. The consuming public has proportionally less disposable income for consumption expenditures and further expansionary stimulation. As the economy contracts, transfer payments rise, providing lessening the drop in disposable income that would have occurred otherwise.

Monetary Policy

In the United States, monetary policy is under the control of the Federal Reserve System (The Fed). The Fed is the monetary authority and central bank for the United States.

In principle, the Fed has three tools that it can use to conduct monetary policy -- open market operations, discount rate, and reserve requirements.

• Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed and is under the authority of the Federal Open Market Committee.


• Discount Rate: The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. Changes in the discount rate are most often used as a signal for monetary policy actions.


• Reserve Requirements: The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits. This tool is seldom used as a means of controlling the money supply.

• Expansionary Monetary Policy: To correct a business-cycle contraction and address the problem of unemployment, the Fed can increase the money supply and decrease interest rates. This is accomplished by buying U.S. Treasury securities in the open market, lowering the discount rate, and reducing reserve requirements.


• Contractionary Monetary Policy: To correct the excesses of business-cycle expansion and address the problem of inflation, the Fed can decrease the money supply and increase interest rates. This is accomplished by selling U.S. Treasury securities in the open market, raising the discount rate, and increasing reserve requirements.

Politics: Two Views

• Conservatives tend to favor individual choices over government, producers over consumers, and lower inflation over lower unemployment. Conservatives tend to prefer contractionary fiscal supply. This keeps inflation rates down, even though higher unemployment rates might result.


• Liberals tend to favor government restrictions on individual choices, consumers over producers, and lower unemployment over lower inflation. Liberals tend to prefer expansionary fiscal supply. This ensures lower unemployment rates, even though higher inflation rates might result.