Fiscal Policy and Stimulus: Crash Course Economics #8

Introduction to Fiscal Policy

Fiscal policy is a legitimate tool enacted by government officials to address fluctuations in the economy. While it may seem at times that government intervention is manipulative, fiscal policy is designed to stabilize economic activity through changes in government spending and taxation.

Business Cycle Overview

• Potential GDP: This is the maximum sustainable output that an economy can produce long-term.

• Recessionary Gap: Occurs when actual output is below potential GDP, leading to unemployment and idle resources.

• Inflationary Gap: When actual output surpasses potential GDP, resulting in super low unemployment and overuse of resources, which can cause increased inflation.

• The economy experiences these cycles of boom and bust, interspersed between periods of stability, as seen in historical fluctuations of real GDP in the U.S. since 1920.

Impacts of Economic Fluctuations

Both recessionary and inflationary gaps can have severe implications:

• Recessions: High unemployment is not just an economic issue; it has social repercussions such as increased suicide rates and domestic violence.

• Inflation: Rising costs can erode savings and contribute to civil unrest, highlighting the need for effective policy intervention.

Role of Fiscal Policy

Fiscal policy serves to smooth out economic fluctuations.

• Expansionary Fiscal Policy: Implemented during economic downturns (deep recessionary gaps) where the government increases spending and/or cuts taxes. This action is intended to stimulate the economy by creating jobs and boosting consumer spending, illustrated by the American Recovery and Reinvestment Act of 2009.

• Contractionary Fiscal Policy: Used during inflationary periods; it involves cutting government spending and raising taxes to cool the economy down. However, this is often politically unpopular, as elected officials prefer to avoid measures that may harm taxpayers.

The Debate on Effectiveness of Fiscal Policy

The impact of fiscal policy is a contentious issue among economists:

• Classical Economic Theory: Maintains that economies will self-correct in the long run and too much government intervention may lead to inflation and increased debt.

• Keynesian Economics: Developed by John Maynard Keynes, this theory advocates for government intervention through spending to counteract low consumer demand. Keynes famously remarked, "In the long run, we are all dead," emphasizing the need for immediate action during economic downturns.

Keynesian vs. Classical Views

• Keynes argued that if consumer spending falls, government spending can fill that void to stimulate the economy. This approach, however, requires deficit spending, leading to national debt concerns.

• Critics of Keynesian approaches worry about "crowding out," where government borrowing raises interest rates, hindering private sector investment, whereas supporters argue that government spending can lead to greater economic activity, especially when capacity is underutilized.

Evaluating Fiscal Policy Through Outcomes

• The performance of economies after stimulus measures can offer insight into their effectiveness:

  • The 2009 U.S. stimulus resulted in a slower recovery compared to pre-stimulus projections but is generally viewed as mitigating worse economic conditions.

  • In contrast, European countries adopting austerity measures during the same period experienced slower economic growth and higher unemployment.

Multiplier Effect

The multiplier effect demonstrates how an initial injection of government spending can lead to a total increase in economic activity that exceeds the original amount spent:

• A dollar spent can lead to further spending through a cascading effect, with estimates suggesting multipliers can range from 1 (under perfect market conditions) to 2 (when there are idle resources available).

• Different types of spending yield different multipliers; for example, welfare spending is seen as highly effective while tax cuts may not produce as significant a growth effect as direct spending.

Conclusion

Fiscal policy is a powerful mechanism for economic stability, especially during recessions. However, its application must be judicious and well-formulated to ensure effective outcomes. Despite the challenges, maintaining consumer confidence is essential for economic recovery, as it drives spending and investment activities. Keynes' theories continue to be relevant and shape monetary policy today, underscoring the importance of balancing intervention while managing public perceptions.