Chapter Introduction


Fiscal Policy



Used with permission of Karl Wimer and the Cartoonist Group. All rights reserved.

What You Will Learn in This Chapter

  • What fiscal policy is and why it is an important tool in managing economic fluctuations

  • Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy

  • Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers

  • Why governments calculate the cyclically adjusted budget balance

  • Why a large public debt may be a cause for concern

  • Why implicit liabilities of the government are also a cause for concern

image | interactive activity

ON FEBRUARY 27, 2009, President Obama signed the American Recovery and Reinvestment Act, a $787 billion package of spending, aid, and tax cuts intended to help the struggling U.S. economy reverse a severe recession that began in December 2007. A week earlier, as the bill neared final passage in Congress, Obama hailed the measure: “It is the right size; it is the right scope. Broadly speaking it has the right priorities to create jobs that will jumpstart our economy and transform it for the twenty-first century.”

Others weren’t so sure. Some argued that the government should be cutting spending, not increasing it, at a time when American families were suffering. “It’s time for government to tighten their belts and show the American people that we ‘get’ it,” said John Boehner, the leader of Republicans in the House of Representatives at the time. Some economic analysts warned that the stimulus bill, as the Recovery Act was commonly called, would drive up interest rates and increase the burden of national debt.

Others had the opposite complaint—that the stimulus was too small given the economy’s troubles. For example, Joseph Stiglitz, the 2001 recipient of the Nobel Prize in economics, stated about the stimulus, “First of all that it was not enough should be pretty apparent from what I just said: it is trying to offset the deficiency in aggregate demand and it is just too small.”

Nor did the passage of time resolve these disputes. True, some predictions were proved false. On one side, Obama’s hope that the bill would “jumpstart” the economy fell short: although the recession officially ended in June 2009, unemployment remained high through 2011 and into 2012, by which time the stimulus had largely run its course. On the other side, the soaring interest rates predicted by stimulus opponents failed to materialize, as U.S. borrowing costs remained low by historical standards.

But the net effect of the stimulus remained controversial, with opponents arguing that it had failed to help the economy and defenders arguing that things would have been much worse without it.

Whatever the verdict—and this is one of those issues that economists and historians will probably be arguing about for decades to come—the Recovery Act of 2009 was a classic example of fiscal policy, the use of government spending and taxes to manage aggregate demand.

In this chapter we’ll see how fiscal policy fits into the models of economic fluctuations we studied in Chapter 16. We’ll also see why budget deficits and government debt can be a problem and how short-run and long-run concerns can pull fiscal policy in different directions.