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Analysis

When the economy begins to suffer from serious recession or inflation, politicians will almost always intervene to try to improve the situation.  Their interventions may or not be good economics—often they're not!—but you can hardly blame the politicians for trying.  Nobody wants to go down in history like Herbert Hoover, the president who became a widely hated figure for failing to use the government aggressively enough to try to end the Great Depression.

Politicians hoping to improve economic conditions have two main tools at their disposal. Fortunately for them (and thus for the rest of us), the basic principles behind them are pretty simple. The core thinking is that inflation and recession are opposites of one another. During periods of recession there is not enough money circulating in the economy. During periods of inflation, there is too much. So the answer to these problems is to either put money in or take money out of the economy.

At this point, economists begin to disagree over who should do the putting in or taking out, and which means should be used to do so. Some favor fiscal policy—adjusting taxes and government spending. But most prefer monetary policy—adjusting interest rates and reserve requirements, and buying or selling bonds.

Fiscal policy is set by the president and Congress; they create the tax system and they decide how the government should spend its money each year. The basic premises behind much of contemporary fiscal policy were introduced by British economist John Maynard Keynes during the Great Depression. Keynes argued, contrary to conventional thinking, that the market and the economy could not regulate itself. During periods of recession, consumers hold on to their money rather than spending it. Businesses were similarly afraid to expand operations and hire more workers. Therefore, the government needed to jump-start the economy by injecting some money into it. The tools for doing so were tax rates and government spending. By lowering taxes people had money to spend; they could buy cars and appliances, or convert their garage into a game room. All of this put people to work stimulating even more spending and job growth. By increasing government spending, the government put money directly into the economy. Building a dam, extending unemployment benefits, or hiring more teachers also put money into circulation and, according to Keynesian fiscal theory, stimulated economic growth.

Fiscal Policy Impact on Aggregate Demand]

Keynes argued that during periods of recession aggregate demand (AD)—the total demand of
consumers, businesses, and government at various price levels—needed to be stimulated through government action. Through tax cuts and increased government spending, aggregate demand (AD1) would be increased (AD2).

Of course, it gets more complicated than this. For starters, policymakers now debate whose taxes should be cut during periods of recession. Traditional Keynesian fiscal policy emphasizes putting money into the hands of middle and lower-class consumers, thereby stimulating the “demand side” of the economy. Others argue that more permanent growth is achieved by cutting business and corporate taxes, and by reducing capital gains taxes and personal income tax rates for wealthier taxpayers. According to these “supply-side” theorists, the money saved through these sorts of tax cuts will be reinvested in new businesses and large-scale expansion, thus generating more jobs.

Regardless of whose taxes you cut, however, this course of action may lead to government budget deficits--that is, government spending may exceed government income. In response, some argue that short-term deficits are acceptable since once the economy starts to grow, tax revenues will increase. Others argue that deficits saddle future generations with debt and lead to high interest rates, crippling future growth.

Fiscal Policy Options 

To Fight Recession:

  • Reduce taxes
  • Increase government spending

To Fight Inflation:

  • Increase taxes
  • Reduce government spending

Why It Matters Today

This one's easy: looked at the news lately?

Just about everybody wants us to get out of this recession, to restore robust economic growth.

But what's the best way to do that?  Keep the government out of things and let the economy run its course?  Or take deliberate government actions to stimulate the economy?

If you want some kind of stimulus, should it come in the form of tax cuts (and if so, for whom)?  Or should it take the form of increased government spending?

Sometimes, a Song Says it Better: Dear Mr. President, by Pink

Pink wants to have an honest conversation with the president (at the time it was George W. Bush) about his fiscal policy. 

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