Chapter 8.1: Government Role
Unit 8.1: Adding the Government…. (Fiscal Policy)
Learning Objectives
By the end of this section, you will be able to:
•Define Economic Fluctuation
•Explain Fiscal Policy, Government Budget and Crowding-Out-Effect
There is a significant amount of controversy over what should be the role of the government in the economy. Many economists (known as Keynesians) believe in the need for some government intervention, because otherwise the economy is likely to fluctuate (go up and down) too much if left on its own. Others, (known as classical economists) claim that government spending is incapable of stabilizing the economy during periods of economic fluctuations. Most agree, however, that government is an important factor in the economy, like it or not.
Examples of government economic interventions are taxes, import and export policies, subsidies for education, and government transfers from one household to the other such as social security payments, and unemployment insurance, Medicare and Medicaid benefits.
There are two ways through which government can affect the economy: fiscal policies and monetary policies. Fiscal policies include taxes, and spending. Monetary policy refer to the way the government controls the money supply through the Federal Reserve.
Let us make sure we understand some key economic terms:
Stabilization policies – fiscal or monetary policies used by the government to stabilize the economy during economic fluctuations.
Economic fluctuations refer to the periodic ups and downs in the level of economic activity (recall unit 6.3 Business Cycle). These fluctuations are often characterized by changes in gross domestic product (GDP), employment levels, inflation rates, and investment levels. Economic fluctuations are typically driven by a combination of various factors including changes in consumer spending, business investment, government policies, technological advancements, international trade, and financial market conditions. There are two primary scenarios of economic fluctuations: expansions and contractions (also known as recession).
Fiscal Policy – is a type of public policy implemented by the government aimed at helping the economy during periods of fluctuations, in other words expansion and recession. There are two tools of fiscal policy: taxes and government spending.
It is important to distinguish between variables that the government controls directly (=government spending) and those that are a consequence of its decisions in combination with the state of the economy (=taxes).
Taxes – the government determines what the tax rate should be. Therefore, one way of using fiscal policy is by increasing or decreasing the tax rate. However, how much total revenue from tax collection depends on the state of the economy. If the economy is expanding and is at full employment tax revenues will be higher. If the economy, is going through a contraction or recession, tax collection tends to be lower.
Government Spending – the government can directly affect output by increasing or decreasing government spending. For example, during periods of recession welfare payments and unemployment insurance will have a positive impact on output. Government spending is a direct tool, it is also autonomous, which means that it does not depend on income.
How does Fiscal Policy Work?
The government has the capacity to a certain extent to stimulate or restrain economic growth through fiscal or monetary policy.
Fiscal Policy
Within fiscal policy the government has two tools to affect the economy. The government can either increase or decrease government spending (G) or/and increase or decrease the tax rates (T).
Expansionary Fiscal Policy will be used when the government wants to stimulate the economy (increase of real GDP) during recession when unemployment is rising.
•increase government spending (G)
•reduction tax rates so disposable income increases leading to an increase in consumption (C).
Contractionary Fiscal Policy is generally used when the government wants to restrain economic growth (slow down GDP growth) to prevent inflation.
•cut back government spending (G)
•increase the tax rates (T) – causes disposable income to decrease and consumption to decreases slowing down GDP.
Important Identities and Definitions
Assume an economy, with no government that does not engage in international trade.
Y= GDP
C= Consumption
I = Investment
And the formula for GDP without government and without trade is:
GDP (Y)= C+I
When we add the government
GDP = C + I + G
Total income of households (Y) is either spent or saved:
Y= total Income
Y=C+S
Disposable income (Yd) equals after tax income, is either C or S.
Yd= Y – T
Disposable income= total income minus taxes
Yd= C+S
Y-T=C+S
Y= C+S+T
The Government Budget
The government budget is made of tax revenues on one hand and government spending on the other hand. Tax revenue is what the government collects from year to year. Government spending covers a range of services that the federal, state, and local governments provide. When the federal government spends more money than it receives in taxes each year, it runs what is called a budget deficit or a fiscal deficit. Conversely, when the government receives more money in taxes than it spends in a year, it runs what is called a budget surplus or fiscal surplus. If government spending and taxes are equal, it has a balanced budget. For example, in 2020, the U.S. government experienced its largest budget deficit ever, as the federal government spent $3.1 trillion more than it collected in taxes. This deficit was about 15% of the size of the U.S. GDP in 2020, making it by far the largest budget deficit relative to GDP since the mammoth borrowing the government used to finance World War II. To put it into perspective, the previous record deficits were experienced during the Great Recession of 2007–2009, when the deficit reached 9.6% of GDP.
Government Fiscal Budget = Tax Revenues – Government Spending
If revenues are larger that spending = budget surplus (or fiscal surplus)
If revenues equal government spending = budget balance
If revenues are lower than spending = budget deficit or fiscal deficit
Fiscal Deficit
When the government spends more money than what it collects in taxes it generates a budget deficit also known as the fiscal deficit. The government will have to finance its budget deficit by issuing debt know as treasury bills, treasury notes, and treasury bonds.
A thought-provoking question: Is it always viable to address a recession, characterized by low GDP and high unemployment, by increasing government expenditures?
Keynesian economics does focus on solving short-run unemployment through government spending. Classical economists will debate and say that increases in government spending causes the “Crowd-Out-Effect.
Crowding-Out Effect
The tendency for increases in government spending to cause reduction in private investment spending and therefore a negative impact on GDP.
What Keynes overlooked is the ripple effect of increased government spending, which generates a surge in the budget deficit, necessitating additional debt issuance by the government. This often leads to a rise in interest rates on treasuries to enhance their appeal. As government expenditure continues to rise, two simultaneous outcomes ensue: inflation and, more significantly, elevated interest rates.
The rise in interest rates prompts the private sector, comprising households and firms, to curtail investment. This results from the increased cost of borrowing due to higher interest rates, coupled with the preference of the private sector to allocate their savings to government treasury bills and bonds offering higher interest rates. This phenomenon is commonly referred to as the crowding-out effect.
This chapter was created by Karen David and is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.
