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Frequently Asked Questions—Part 4
By : Lynn Huselton
Plano East Senior High
Plano, TX
Q.How does fiscal policy slow or stimulate economic growth?
A.Fiscal policy is the taxing and spending practices of a government. John Maynard Keynes suggested the use of government spending and taxing to correct the problems of the great depression. At that time in history the United States was experiencing high levels of unemployment. It seemed that the old adage of supply creates its own demand was not working. Interest rates were very low, banks had money available for loans, yet businessmen chose not to invest in new factories. Keynes suggested that if the government were to run a deficit budget, that is, increase government spending and cut taxes, the result would be enough aggregate demand to stimulate the economy. Aggregate demand is made up of consumer spending, business investment, government spending and net exports. (AD = C + I + G + Xn). Keynes stated that due to the massive unemployment, consumer spending was insufficient to encourage businessmen to build new factories. The government spending would temporarily replace the consumer spending. As the economy grew, nearing full employment and pressure was placed on prices causing them to rise, the government could now run a surplus budget. In other words, taxes could be raised and government spending could be cut. The cause effect steps of this policy are as follows. Government pursues a deficit budget lowering taxes. Lowering taxes would cause people to have more disposable income. This increased disposable income would allow people to increase their consumer spending. Consumers would now purchase products causing orders for those products to increase. Producers would fill those orders calling people back to work. After a while the economy would be near full employment. At this point there would be pressure upward on prices. To simplify matters, consumer spending is a component of aggregate demand. When aggregate demand increases, the price level, output and employment in the economy will increase. The government would also be borrowing money to increase its spending. Government could create projects such as building hydroelectric plants or highways. This spending would cause the orders for products such as concrete, etc. to increase. Businesses would fill these orders and in doing so call people back to work. Government spending is a component of aggregate demand. By increasing aggregate demand in the intermediate range of the aggregate supply curve there is pressure upward on prices as well as an increase in output and employment. The opposite of the above steps would result in slowing the economy. Note the following line of code and graphs to help students remember the cause and effect steps of fiscal policy.
PROBLEM GRAPH
SOLUTION GRAPH
There are limitations associated with the performance of fiscal policy. Most notably would be politics. It is very difficult to increase taxes and to cut government spending. People profess to want government spending cut until it concerns cutting a spending program that will affect them personally. A second limitation is forecasting and time lags. It is difficult to predict where we are in the business cycle. Also it takes a long time for a bill in Congress to become law. Many changes could occur in the economy while we wait for the wheels of democracy to turn. Another limitation is the fact that Congress and the Federal Reserve should coordinate fiscal and monetary policy. This is seldom done. Also there is a trade off between price level, inflation, and output and employment when shifting the aggregate demand curve.
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