Fiscal Policy. Image Source: Wikimedia Commons

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1 Fiscal Policy Image Source: Wikimedia Commons Until the Great Depression, the government would have a hands off stance towards the economy. When a depression hits, Congress and the President would leave the fate of the economy to its own devices. The economy would then be regulated by businesses and the amount of money the government wants to print. The economy is made up of a constant series of ebbs and flows, or peaks and troughs. During the time period before government intervention in the economy, these ebbs and flows were uncontrollable and potentially devastating. There were often panics and bank runs. During the 1920s, it was no different. 131

2 The 1920s are known as the Roaring Twenties for a reason. The economy was doing great and people were constantly making more money. Americans would consume more, which meant high demand and therefore high production. Eventually production was so much that it outpaced demand and businesses were overproducing. Despite this, the companies continued to produce, figuring this was the only way to keep the economy going. Eventually, in 1929, the companies began to fail due to overproduction and no revenue. Their stocks became worthless. This was the beginning of the Great Depression and President Hoover took the normal stance that the economy would eventually sort itself out. Come 1932, Hoover had eventually attempted to fix the economy through the use of the newly designed Keynesian economics. Unfortunately, it was too little, too late and the economy was already in a full depression. That s when Franklin D. Roosevelt came in with his New Deal. This was the official beginning of fiscal policy in practice. What is Fiscal Policy? Roosevelt s fiscal policy as part of the New Deal did not stimulate the economy as hoped, mainly because it was doing so poorly by the time he took office. It took the outbreak of World War II and a surge in production to get the economy going, however, the precedent of the government s fiscal policy remained. Fiscal policy in the United States basically refers to how the government manages the budget in times of crisis. Before the Depression, the government s budget was small because it did not bother to take on too many responsibilities. However, after the Depression, the theory came in that spending more money would boost the economy s performance. Fiscal policy therefore refers to the actions and precautions the government takes to intervene in a recession or prevent one altogether by actively participating in the economy. In the context of AP macro, there are two types of fiscal policy. 132

3 1. Expansionary Policy When a recession hits, people buy less due to either losing work or saving up. This means that output falls as well as demand. The government aims to expand the economy by stimulating demand. This can be done by increasing spending to create programs such as public works (thus employing people and giving them a wage to spend money) or by reducing taxes (people have more money to spend). Expansionary policy can be presented on a graph as shown: As presented in the graph, the government enacts policies which increase demand. In theory, this policy will increase short run aggregate supply (SRAS) while also increasing the price level (AP Macro Review: As demand grows, prices increase). When demand and price levels grow, so too does the GDP (the total output of the economy). GDP growth means the economy has exited the recession. 133

4 It should also be noted that in any policy the long run aggregate supply (LRAS) remains the same. That is because any fiscal policy is temporary and only meant for the short run. According to this theory, there should be recovery in the long run and ideally GDP will be at a higher level than it was. 2. Contractionary Policy In contrast, contractionary policy is as shown: As you can recall, fiscal policy is a short term solution. Eventually it has to end. If a government pursues expansionary policy for too long, spending will cause a deficit and increase the money supply. Increasing money supply will cause inflation and prices will rise too high for regular consumption. In order to combat this, the government will enact contractionary policy. 134

5 As shown in the graph, contractionary policy aims to decrease aggregate demand, which in turn reduces the short run aggregate supply and therefore the long run aggregate supply. This reduces the output of the economy (real GDP) and price levels. How does Fiscal Policy Work? Now that you know what fiscal policy is, you should figure out what it means. As part of your AP Macroeconomics review, you need to know the reasons why a government enacts policies so as to understand why these policies work. In short, expansionary policy is to combat a contraction in the economy and contractionary policy is to combat over inflation. The economy goes through cycles, which are collectively known as business cycles. If you were to plot a graph of the economy where the GDP represents the economy and is represented by a line running over time, you would see that line dip and rise. When the line dips it is called a recession. The lowest point of that dip is the trough, and then there is a rise in the economy to a peak. The peak is the turning point to where the economy dips again to another trough. GDP is the measure of all production in the economy. In the long run, GDP should always be increasing, which means it would be a straight line. The short run GDP is what determines a dip or rise in the economy. When the economy is in a dip for more than one quarter (3 months), then it is in a recession and experiencing negative growth. Real GDP, as shown in the graph, does not necessarily reflect the growth of the economy as a whole but rather shows the short term effects of the policy on prices. What fiscal policy aims to do is combat the effects of a recession to make sure it doesn t spiral into a depression, which is either a recession lasting 2 or more years or a decline in real GDP exceeding 10% of when the recession started. As previously stated, recessions are a normal part of the business cycle and reflect a healthy economy. 135

6 When a government enacts expansionary policy it is meant to put the economy on the track of recovery and stop a trough short of becoming a depression. Increasing spending and decreasing taxation helps to make this possible by increasing demand, which increases consumption and helps the economy grow. Expansionary policy is important during moments of crisis that cause an unexpected shock. Contractionary policy is much more controversial. It is essentially a government sanctioned miniature recession that is meant to reduce spending to help control inflation. While inflation means growth of the economy in the short run (i.e. growth of real GDP) this is not reflective of the state of the economy. Increasing price levels means that consumption is high, but unsustainable. Every time the price level increases, the unit of currency will buy less. Over time, this will stifle consumption and demand to the point of causing a recession. Contractionary policy is meant to create a recession in anticipation of a future recession from lack of demand. This way, the government can manage the recession in order to keep the economy from spiraling out of control. There are two forms of enacting this policy: either cutting spending or increasing taxes. Politically, increasing taxes is extremely unpopular and can cause the politician to lose their jobs (as happened with George H.W. Bush). The second option, cutting spending, is therefore a much more desirable option because its effects are less readily visible to voters. Ideally, governments should be able to foresee patterns in the business cycle and enact the correct policy according to what is appropriate. However, the government cannot necessarily control the long run effects of the fiscal policy. This can lead to hyperinflation in the case of too much expansionary policy or scarcity in the case of too much contractionary policy. 136

7 Conclusion The government uses fiscal policy to help control the effects of the business cycle on the economy and GDP growth. Expansionary policy increases demand and helps spur growth in the short run. Contractionary policy is used to curtail too much growth that could eventually lead to a major recession. The relationship between these two policies, in theory, helps to create a flatter cycle. There is much debate over whether or not these policies are truly effective in the economy. Indeed, the first enactment of fiscal policy, the New Deal by Franklin D. Roosevelt had a minimal effect on the depression. This is due to the fact that the government s policy is at the whim of the severity of the shock that caused the recession in the first place. In the context of an AP macroeconomics review, however, these fiscal policies are enacted in the moment of either inflation (contractionary) or a recession (expansionary) with the aim of controlling demand and decreasing or increasing the short run aggregate supply. 137