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Economics U$A: 21st Century Edition

Fiscal Policy (Macroeconomics)

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In 1954 relying on “automatic stabilizers,” President Dwight Eisenhower withheld raising taxes in order to encourage consumer spending. In the 1960s, newly elected John F. Kennedy and economic advisor Walter Heller pushed Congress to approve a $12 billion tax cut stimulus. The Employment Act of 1946 was the first time that government tried to employ fiscal policy. But, by 2010 economists disagreed about whether fiscal policy was dead, as they argued over the success or failure of President Obama’s stimulus plan. These stories are all examples of how government attempts to fine-tune tax and spending policies to reduce the severity of business-cycle fluctuations.

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Unit Overview


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.


  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 that 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.

Meet the Series Experts

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. He taught at Harvard University for many years, taking leaves to serve in the presidential administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson. He also served as United States Ambassador to India under President Kennedy. Due to his prodigious literary output, he was arguably the best-known economist in the world during his lifetime and one of a select few people to be twice awarded the Presidential Medal of Freedom. Dr. Galbraith received his B.A. from the University of Toronto and M.A. and Ph.D. in Agricultural Economics from the University of California, Berkeley.

Douglas Holtz-Eakin

Currently he is the 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. He taught at Princeton and Columbia Universities, then served as a Senior Staff Economist on President George H.W. Bush’s Council of Economic Advisers and as a Faculty Research Fellow and Research Associate at the National Bureau of Economic Research. He joined the faculty at the Maxwell School of Citizenship and Public Affairs, becoming Chair of the Department of Economics, 1997–2001. He is President of DHE Consulting, LLC, and has served as Director of the Maurice R. Greenberg Center for Geoeconomic Studies and the Paul A. Volcker Chair in International Economics at the Council on Foreign Relations, as well as a senior visiting fellow at the Peterson Institute for International Economics. Dr. Holtz-Eakin received his B.A. from Denison University and Ph.D. in Economics from Princeton University.

Walter Heller

Influential American economist of the 1960s and Chairman of President John F. Kennedy’s Council of Economic Advisers, 1961–1964. He was a Keynesian who promoted cuts in the marginal federal income tax rates, which were passed by President Johnson and Congress after Kennedy’s death and credited for boosting the economy. He developed the first “voluntary” wage-price guidelines and was one of the first to emphasize that tax deductions and tax preferences narrowed the income tax base. As adviser to President Johnson, he convinced the president to adopt a major economic initiative—the “War on Poverty.” But he resigned when Johnson escalated the Vietnam War without raising taxes, thus setting the stage for an inflationary spiral. Before and after government service, he taught at the University of Minnesota where he became Chair of the Department of Economics. Mr. Heller received his B.A. from Oberlin College.

Herbert Stein

Senior fellow at the American Enterprise Institute and Chairman of the Council of Economic Advisers under presidents Richard Nixon and Gerald Ford. From 1974 to 1984, he was the A. Willis Robertson Professor of Economics at the University of Virginia, where he formulated “Herbert Stein’s Law”; this stated, “If something cannot go on forever, it will stop,” meaning that if a trend cannot go on forever, there is no need for action or a program to make it stop; it will stop of its own accord. This notion gave him the reputation of being a pragmatic conservative, jokingly referred to as a “liberal’s conservative and a conservative’s liberal.” He was the author of The Fiscal Revolution in America and was on the board of contributors of the Wall Street Journal. Dr. Stein received his B.A. from Williams College and Ph.D. in Economics from the University of Chicago.

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Quiz Addendum:
3. Answer explanation:
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.


  • automatic stabilizers
    Structural features of the economy that tend by themselves to stabilize national output, without the help of legislation or government policy measures.
  • balanced budget
    A budget in which tax revenues equal government expenditures.
  • budget surplus
    The amount by which tax revenues exceed government expenditures.
  • deficit
    When government spending is greater than government revenue.
  • government purchases
    Federal, state, and local government spending on final goods and services, excluding transfer payments.
  • government transfers
    Government revenue paid to individuals or businesses not in exchange for goods or services; e.g., welfare, financial aid, Social Security, etc.
  • inflationary gap
    A positive gap between actual and potential output.
  • multiplier
    Number which indicates the magnitude of a particular macroeconomics policy measure.
  • progressive tax
    A tax whereby the rich pay a larger proportion of their income for the tax than do the poor.
  • proportional tax
    A system in which all levels of income are taxed at the same rate; a.k.a. flat tax.
  • recessionary gap
    A negative gap between actual and potential output.

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Economics U$A: 21st Century Edition


Produced by the Educational Film Center. 2012.
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  • ISBN: 1-57680-895-5