Fiscal Policy and Its Impact on Economic Growth and Stability

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Can Fiscal Policy Increase Economic Growth?

Introduction to Fiscal Policy and Economic Growth

Fiscal policy is a key tool used by governments to influence macroeconomic outcomes such as economic growth, employment, and price stability. During economic downturns, such as the Covid-19 recession, governments may enact large discretionary policy actions to support households and businesses, often resulting in significant budget deficits. Understanding the mechanisms and consequences of fiscal policy is essential for analyzing its effectiveness in both the short and long run.

What Is Fiscal Policy?

Definition and Types of Fiscal Policy

Fiscal policy refers to changes in federal government purchases, transfer payments, and taxes intended to achieve macroeconomic policy objectives.
State taxes and spending are generally not aimed at affecting national level objectives.
Some government spending and taxes automatically adjust with the business cycle; these are called automatic stabilizers (e.g., unemployment insurance payments increase during recessions).
Discretionary fiscal policy refers to intentional actions by the government to change spending or taxes.

The Federal Government's Role in Fiscal Policy

Trends in Government Expenditures

Before the Great Depression, most government spending was at the state or local level. Today, the federal government accounts for two-thirds to three-quarters of total government expenditures.
As a percentage of GDP, federal expenditures are now over 30%, but a smaller proportion is spent on direct purchases of goods and services (mainly military spending).

Federal Government Expenditures and Revenues (2022)

Purchases: Defense, salaries of federal employees, national parks, scientific research.
Expenditures: About half are transfer payments (Social Security, Medicare, unemployment insurance).
Other expenditures include grants to state/local governments, crime prevention, education, and interest on the federal debt.
Revenues: Mostly from individual income taxes and payroll taxes (Social Security and Medicare), with smaller shares from corporate income taxes, excise taxes, tariffs, and other fees.

Social Security and Medicare: Fiscal Time Bombs?

Challenges and Sustainability

Social Security and Medicare reduce poverty among the elderly and improve health for the poor, but face long-term sustainability issues due to an aging population and rising healthcare costs.
Projected budget shortfall for these programs through 2092 is nearly $16.8 trillion (present value).
Potential solutions include increasing taxes, decreasing benefits, raising eligibility ages, and most importantly, reducing medical costs.

The Effects of Fiscal Policy on Real GDP and the Price Level

Mechanisms of Fiscal Policy

Fiscal policy is enacted through changes in government purchases and taxes.
A change in government purchases directly affects aggregate demand (AD).
A change in taxes affects income, which in turn affects consumption, thus having an indirect effect on AD.

Expansionary vs. Contractionary Fiscal Policy

Expansionary fiscal policy: Increasing government purchases or decreasing taxes to raise real GDP and reduce unemployment when real GDP is below potential GDP.
Contractionary fiscal policy: Decreasing government purchases or increasing taxes to lower real GDP and reduce inflation when real GDP is above potential GDP.

Aggregate Supply and Demand Shocks (Covid-19 Example)

Economic shutdowns shifted the short-run aggregate supply (SRAS) curve left.
Aggregate demand (AD) also shifted left, prompting a large expansionary fiscal policy to restore real GDP to its potential, but at the cost of higher inflation.

Countercyclical Fiscal Policy

Problem	Type of Policy Required	Actions by Congress and the President	Result
Recession	Expansionary	Increase government purchases or cut taxes	Real GDP and price level rise
Rising inflation	Contractionary	Decrease government purchases or raise taxes	Real GDP and price level fall

Additional info: These effects assume ceteris paribus (all else equal), including monetary policy. Contractionary policy typically lowers inflation relative to what it would have been, not necessarily causing prices to fall.

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

Static vs. Dynamic Models

Static models assume constant potential GDP and price level.
Dynamic models allow for changes in potential GDP and price level over time, providing a more realistic framework for fiscal policy analysis.

Expansionary and Contractionary Policy in the Dynamic Model

Expansionary policy increases aggregate demand to reach full employment, but may result in a higher price level.
Contractionary policy decreases aggregate demand to prevent overheating and high inflation, ideally maintaining full employment.

The Government Purchases, Tax, and Transfer Payments Multipliers

The Multiplier Effect

An autonomous increase in government spending directly raises aggregate demand.
This spending becomes income for others, who then increase their consumption (induced increase), multiplying the initial effect.
Multiplier effect: The process by which a change in autonomous expenditure leads to a larger change in real GDP.

Formulas for Multipliers

Government purchases multiplier:
Tax multiplier:
Transfer payments multiplier:

Examples and Applications

If each increase in spending induces half as much consumption spending, a $100 billion increase in government purchases results in an additional $100 billion in induced consumption spending over time.
The tax multiplier is negative: an increase in taxes decreases equilibrium real GDP, and vice versa. It is also smaller in absolute value than the government purchases multiplier because tax cuts are partially saved.
Transfer payments, such as stimulus checks, increase household disposable income and thus consumption, with a positive multiplier effect.

Multiplier Effect and Aggregate Supply

An increase in aggregate demand raises both real GDP and the price level, as the short-run aggregate supply curve is upward sloping.
The resulting increase in real GDP is smaller than the total increase in aggregate demand due to the upward pressure on prices.

Multipliers Work in Both Directions

Increases in government purchases or tax cuts have positive multiplier effects.
Decreases in government purchases or tax increases have negative multiplier effects.
Example: A reduction in defense spending affects contractors, suppliers, and employees, spreading throughout the economy.

Limits to Using Fiscal Policy to Stabilize the Economy

Challenges and Crowding Out

Timing issues: Legislative delays (Congress must agree), implementation delays (projects take time to start).
Crowding out: Government spending may reduce private spending by raising interest rates, which lowers consumption, investment, and net exports.

Short-Run and Long-Run Effects of Crowding Out

Short run: Temporary increases in government purchases raise interest rates, partially offsetting the initial increase in spending.
Long run: The increase in government purchases has no effect on real GDP, as reductions in private spending exactly offset the increase. The main effect is a larger government sector.

Why Was the Recession of 2007–2009 So Severe?

Severity and Comparison

Duration	Decline in Real GDP	Peak Unemployment Rate
Average for postwar recessions	-1.7%	7.6%
Recession of 2007–2009	-4.0%	10.0%

Recessions following financial crises are especially severe, with larger increases in unemployment and declines in GDP.

Fiscal Policy in Action: The Stimulus Package of 2009

Implementation and Effectiveness

In 2008, Congress authorized a one-time tax rebate, boosting current incomes but resulting in only modest increases in spending.
The 2009 American Recovery and Reinvestment Act was the largest fiscal policy action in U.S. history, with two-thirds as spending increases and the rest as tax cuts and credits.
Measuring the effect of the stimulus is difficult due to other factors affecting GDP and employment; estimates from the Congressional Budget Office (CBO) are often used for neutrality.

CBO Estimates of the Effects of the Stimulus Package

Year	Change in Real GDP (percentage change)	Change in Unemployment Rate (percentage points)	Change in Employment (millions of people)
2009	0.4 to 1.8	-0.1 to -0.5	0.3 to 1.3
2010	0.7 to 3.1	-0.4 to -1.1	0.9 to 3.7
2011	0.6 to 2.1	-0.2 to -1.4	0.6 to 3.6
2012	0.1 to 0.8	0.0 to -0.6	0.1 to 1.2
2013	0.0 to 0.2	0.0 to -0.2	0.0 to 0.3
2014	0.0 to 0.1	0.0 to 0.0	0.0 to 0.1

Conclusion: The stimulus package reduced the severity of the recession but did not fully restore the economy to full employment.

Estimates of the Sizes of Government Purchases and Tax Multipliers

Variation in Multiplier Estimates

Economists Making the Estimate	Type of Multiplier	Size of Multiplier
Congressional Budget Office	Government purchases	0.5–2.5
Valerie Ramey, UC San Diego	Military expenditure	0.6–1.1
Robert Barro, Harvard, and Charles Redlick, Bain Capital	Military expenditure	0.4–0.5 after 1 year; 0.6–0.7 after 2 years
John Cogan & John Taylor, Stanford; Tobias Cwik & Volker Wieland, Goethe Univ.	Permanent increase in government purchases	0.4
Christina Romer & David Romer, UC Berkeley	Tax	2–3
Congressional Budget Office	Tax	0.3–1.5 for 2-year cut for lower/middle income; 0.1–0.6 for 1-year cut for higher income
Robert Barro, Harvard, and Charles Redlick, Bain Capital	Tax	1.1

Additional info: Estimating multipliers is difficult due to simultaneous changes in aggregate demand and supply, and different methodologies yield varying results.

Deficits, Surpluses, and Federal Government Debt

Definitions and Trends

Budget deficit: Government expenditures exceed tax revenue.
Budget surplus: Government expenditures are less than tax revenue.
The U.S. federal government usually runs a deficit, especially during wartime or recessions.
Automatic stabilizers (e.g., increased transfer payments during recessions) help limit the severity of downturns.

The Federal Budget as an Automatic Stabilizer

In 2009, the deficit was 9.3% of GDP, rising again in 2020.
The cyclically adjusted budget deficit/surplus measures what the deficit or surplus would be if the economy were at potential GDP.
In 2009, the CBO estimated the deficit would be 7.6% of GDP even if GDP were at potential, indicating the role of automatic stabilizers.