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Fiscal Policy: The Best Case
The Limits to Fiscal Policy
When Fiscal Policy Might Make Matters Worse
So When Is Fiscal Policy a Good Idea?
Takeaway
The U.S. economy was falling into a severe recession. The S&P 500 stock index was plummeting. And in the third quarter of 2008, consumer spending dropped by 3.7%, the largest drop in 28 years. Consumer spending is a large fraction of GDP (as you will recall from Chapter 26), so the sudden drop in spending pushed down the growth rate of GDP. To encourage more spending, President George W. Bush authorized the Treasury to send checks to millions of U.S. taxpayers. Could the new money jump-start the economy? Not this time. Consumer confidence was ebbing. Even with a few extra bucks in their pocket, consumers weren’t ready to spend. The economy continued to worsen and in 2009 President Barack Obama tried a different approach: hundreds of billions of dollars in new government spending on roads, bridges, education, and other infrastructure, combined with additional tax cuts and also aid for state governments. If the American consumer wouldn’t spend, then the American government would.
Fiscal policy is federal government policy on taxes, spending, and borrowing that is designed to influence business fluctuations.
Fighting a recession with tax cuts and fighting a recession with increased government spending are two forms of fiscal policy. Fiscal policy is federal government policy on taxes, spending, and borrowing that is designed to influence business fluctuations.
In this chapter, we use the aggregate demand and aggregate supply curves familiar to you from Chapter 32 to understand fiscal policy. We start with the situations in which fiscal policy is most effective, move to the cases where fiscal policy doesn’t matter much at all for macroeconomic performance, and close by considering when an activist fiscal policy is downright harmful.
As we said, two general categories of fiscal policy are used to fight a recession:
The government spends more money
The government cuts taxes, giving people more money to spend.
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In both cases, the goal is more spending, although in the first case the new spending comes from government and in the second it comes from the private sector. We will start by focusing on expansionary fiscal policy done through increases in government spending because that is the most straightforward case of fiscal policy and the underlying issues are easiest to identify.