Unit 18 — Fiscal Policy

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Purpose:

To show that a key element of Keynes’s contribution is that, at least in theory, the government can fine-tune tax and spending policies to reduce the severity of business-cycle fluctuations.

Objectives:

  1. Government spending on goods and services is an injection into the circular flow of the economy. As government purchases rise, the demand for GDP/GNP rises and, assuming that the economy is below full capacity, GDP/GNP produced will rise. The rise in GDP/GNP is larger than the rise in government spending. In fact, it is equal to the rise in government spending times the multiplier.
  2. Taxes have a similar but opposite effect on GDP/GNP. Moreover, the impact of taxes is indirect. A tax cut results in an increase in disposable or after-tax income. This additional income can either be saved or spent. Only that portion of the tax cut which is spent is considered an injection into the circular flow. Consequently, a tax cut of the same magnitude as a spending increase will usually have a smaller impact on GDP/GNP than the spending increase. Rises in transfer payments such as Social Security and welfare payments have the same impact on GDP/GNP as a tax cut.
  3. Generally speaking, the larger the government deficit (taxes less spending) the larger will be the net injections into the circular flow and the larger will be the volume of the flow (GDP/GNP). The opposite is true for surpluses. Thus, by changing the spending and tax policies the government can, in the abstract, stimulate growth in the economy or slow the economy down.
  4. The U.S. economy also has a number of built-in stabilizers which raise the deficit (lower the surplus) in recessions and lower the deficit (raise the surplus) in recoveries. These include unemployment benefits and welfare payments, which rise when GDP/GNP is falling and vice versa. The progressive structure of the U.S. tax structure also serves as a stabilizer. In a recession, tax receipts are lower because of higher unemployment. This means that the deficit is larger. The reverse is true in periods of high growth.

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Meet the Series Experts

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John Kenneth Galbraith

John Kenneth Galbraith

Economist known as the leading proponent of 20th-century political liberalism, and a prolific author who produced four dozen books and more than a thousand articles, including the popular trilogy American Capitalism, The Affluent Society, and The New Industrial State.

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Walter Heller

Walter Heller

Influential American economist of the 1960s and Chairman of President John F. Kennedy’s Council of Economic Advisers, 1961–1964.

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Doug Holtz-Eakin

Douglas Holtz-Eakin

Currently President of the American Action Forum and a Commissioner on the Congressionally-chartered Financial Crisis Inquiry Commission. Under President George W. Bush, he was Chief Economist for the Council of Economic Advisers and Director of the Congressional Budget Office.

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Herbert Stein

Herbert Stein

Senior fellow at the American Enterprise Institute and Chairman of the Council of Economic Advisers under presidents Richard Nixon and Gerald Ford.

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WHAT’S YOUR
ECONOMICS IQ?

  1. Inflation is a sign that the aggregate demand curve is:

    somewhere within the vertical range.

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  2. The Council of Economic Advisers was established by the Employment Act of 1946 to:

    help the president carry out the objectives of that Act.

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  3. Economist Ruth B. feels that too much reliance on government intervention through fiscal policy is hazardous to our nation’s future economic health. “We’ve seen the automatic stabilizers work in the past,” she contends. “Why not let things take their course? Government spending is high enough right now to keep the economy functioning well without so much steering on our part. It may well do better without us.” Which of the following probably BEST describes the way today’s economists would view Ruth’s argument in this scenario?

    It’s an approach that makes sense when things are generally functioning well, but economic stabilizers have limited impact. This option makes the most sense. The economic stabilizers do keep the economy functioning well, in many cases without government intervention (as the Eisenhower scenario illustrates), but they are limited. They can only do so much. When severe economic problems arise, more intervention is essential.

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  4. Which of the following BEST explains why automatic stabilizers have more effect on our economy now than they did during the 1930s?

    spending has increased dramatically since the 1930s.

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  5. When President Kennedy took office in 1961, he inherited an economy marked by high unemployment. His advisers, led by Walter W. Heller, pushed hard for a tax cut to deal with the problem. Ultimately, after much consideration and deliberation, Kennedy agreed to the strategy, and the tax cut of 1964 became a reality just months after Kennedy’s assassination. Which of the following BEST describes the impact of the 1964 tax cut, as today’s analysts see it?

    The impact was very slight, disappointing to those who had favored a government spending package in place of the tax cut.

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  6. Since 1929, government expenditures have grown faster than total output. Which of the following has contributed LEAST to this rapid growth in govenrment spending?

    Shifts in equilibrium NNP.

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