Triplets and the Tax Reform Blues
Optimism and Confidence: Rocky Balboa for President
Lesson 6. Sandersonian Economics
Mindless Austerity vs Mindless Irresponsibility
Krugman versus Reinhart & Rogoff


The idea of fiscal policy in the short-run is pretty simple. If AD is too low, then the government would:

  • Buy more goods and services
  • Increase transfer payments
  • Reduce tax rates on household income
  • Reduce taxes or change regulations that might increase business income

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Buying more goods and services would: Increasing transfer payments would: Reducing tax rates on household income would: Reducing taxes or changing regulations that increase business income would:
directly increase spending and AD increase disposable income and if households behave normally, the increase in disposable income should increase spending by a predictable amount* increase disposable income and if households behave normally, the increase in disposable income should increase spending by a predictable amount* increase business spending but the size of the increase would depend on many other factors (including business confidence)

*For example, an increase of disposable income of $100 should increase consumer spending by roughly $90 if people save the other $10.

Once AD increased, then firms would see the increased demand for their products and react by raising output, raising prices, or some combination of the two. The larger (smaller) the size of the negative GDP gap, the more we would expect an output (inflation) response.

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Deficits are a two-way street

When talking about fiscal policy our tendency is to focus on one direction of change – this is, how government deficits impact the economy. But sometimes the reverse can happen – changes in the economy cause changes in the government deficit. We outlined above how a given increase in the government deficit should lead to higher economic growth and inflation. So a business planner who studied this issue might associate an increase in the government deficit of, say $100 billion, with a particular increase in real GDP of, say $200 billion. These numbers are illustrative only, but let’s assume we believe this relationship is stable. We have to be very careful with how we apply it. .

“The Role of Fiscal Policy” from the FRBSF Economic Letter, Sept 6, 2002 by Carl Walsh. This article is available at:

This reading is useful for understanding the difference between automatic changes in the government budget and those that are a result of new policy changes. There is a two-way relationship between fiscal policy changes and the economy. Policy impacts the economy – but the economy causes automatic changes in government spending and revenues.

We have to be careful because this is a two-way relationship. It is also true that the economy can affect government spending and taxes automatically without any change in policy. Why? Because spending and taxes change when the country’s income changes. For example, when the economy enters a recession and incomes are falling, people pay less in taxes. People who become unemployed may pay much less in taxes. Also in a recession the government would pay out more in transfer payments since more people would be eligible for unemployment insurance and poverty assistance. So the general rule is:

A stronger economy produces smaller government deficits (larger surpluses)

A weaker economy produces larger government deficits (often called automatic stabilizers because the weakness produces more spending and less taxation than normal)

So we see why we need to be careful with government deficit data. In any given year the deficit might change, but for more than one reason. For example from 2001 to 2002, the U.S. government deficit swung from a surplus of $47 billion to a deficit of $254. That was a swing of about $300 billion. Some of that swing was caused because government had a specific AD policy to increase the government deficit. The rest of it was caused by a recessionary economy and automatic stabilizers. Let’s suppose AD policy caused $200 billion and automatic stabilizers caused the other $100 billion. In that case, you would use the $200 billion and not the $300 billion to predict how much AD policy will impact the economy. Unfortunately, we do not always know right away how much of an announced change in the government deficit is from policy and how much is from automatic stabilizers. Therefore, this absence of complete information means we may not have a good feeling for how the change in the government deficit will impact real GDP.

This automatic part of government can also produce difficulties when it is decided that government spending needs to be controlled better. For example, most entitlement programs are not part of each year’s political circus – that is they are not subject to annual appropriations that must be approved and signed into law. One estimate by Andrew Balls and Christopher Swann (found in “Healthcare puts federal budget on a rocky road,” Financial Times, Jan 26, 2005) is that overall U.S. entitlement spending will rise from 42% of federal spending in 2005 to 55% in 2015. Medicare, for example, is expected to grow by 9% per year and Medicaid by almost 8% per year. If the Bush government is going to reduce the growth of government spending then it has a tough choice. It must work to significantly reduce non-mandatory spending – or it must make important changes to the laws that guide important ongoing mandatory spending on Social Security, Medicare, and other entitlement programs.

Difference of opinion about short-run AD policies

The above short-run story was pretty simple. The economy has an apparent AD deficiency, the government runs a deficit, and that causes AD and the economy to expand. But things are never as simple as they seem. Consider some of the controversies surrounding the use and impact of fiscal AD policy.  As you consider them, think about being someone about to commit $100 million to a new program and how this impacts your view of the future economic environment:

  • Inside lags refer to the time it takes for the political process to recognize a problem exists and then to legislate a solution. Some experts believe that by the time the government goes about doing something about the problem it is often too late. Thus, we may get an AD remedy after the problem is gone.
  • Outside lags refer to how long it takes for a government policy to impact the economy. The outside lag differs for various forms of fiscal policy. For example, it is possible to change disposable income very quickly with an income tax change. We may not pay our taxes until April, but most of us have automatic withholding each month. So the government could be getting more money into our hands within a month of two after the legislation is signed. That contrasts greatly with a decision to build more roads or nuclear reactors. It could take a very long time before a contractor is found and does enough work to warrant being paid.
  • The apparent persistence of the real GDP gap is very important as to the policy response. The world is full of uncertainty about the future. So when a negative real GDP gap becomes highly noticeable, there is always a question of how long it will last. If it is the result of a very temporary factor and will vanish in the next six months, then it doesn’t make sense to enact a policy – it will be gone by the time the policy starts to impact the country. The inherent persistence of any real GDP gap is an arguable matter. Inasmuch as there is a wide difference of opinion about the durability of the problem, there may be wide difference of opinion about whether it should be the subject of a new fiscal policy.
  • Philosophy may enter the picture too. Liberals believe it is the responsibility of the government to correct an ailing economy. Conservatives believe the opposite.
  • Rationality comes into play when it comes to some tax increases. David Ricardo, an economist from the 19th century, believed that people can be very rational. This rationality might reduce the impact of a tax change.

For example, suppose the government tells you they are going to reduce your taxes by $100. They expect you to go spend most of that amount.

But Ricardo said that rational people might save ALL of it. Why? Because rational people would understand that this tax reduction will cause a government deficit. Later, the government would have to raise taxes to eliminate the deficit. So one day they would give you $100 and then the next day they would take it away. If you knew that would happen, it would be best to just hold on to it and not spend it. Well, I guess Ricardo never met my brother-in-law Bob. Bob would have spent $110. Anyway, Ricardo does raise an interesting question about HOW MUCH of any given tax change would result in a change in spending and AD.

  • Inflation tradeoffs interfere with any fiscal policy decision. For example, there may be a difference of opinion about the size of the GDP gap. Those who believe it is very small would worry that an aggressive expansionary fiscal policy would create too much inflation. They might resist voting for such a policy if inflation at the time seemed more of a problem than the real GDP gap.
  • Investment and durable goods tradeoffs are always a worry with fiscal deficits. Consider what happens when the government is selling bonds to finance a deficit. This active selling of bonds can cause interest rates to rise. Any interest-sensitive spending could be impacted if interest rates rise enough. That means that the demand for cars, appliances, houses, plant, and equipment might be “crowded out” or reduced. It is ironic that a tax cut or government spending policy designed to increase national domestic spending and AD might end up causing some specific sectors of national domestic spending to decline. If the country feels that continued strength of these interest-sensitive sectors is critical, they might not want to support a given fiscal policy.
  • International tradeoffs can also interfere with the passage of legislation. For example, larger government deficits can impact the exchange rate and the country’s exports and imports. Here is the simple story. Recall that government deficits mean the government must sell bonds. If foreigners buy those bonds in large numbers, this means they need to buy large amounts of dollars in foreign exchange markets. This activity might cause the value of the dollar to increase. The latter makes a country’s exports less competitive and steers both domestic and foreign buyers away from U.S. markets to other ones. Thus a policy aimed at raising the domestic component of AD could end up reducing net exports – and reducing the foreign part of AD.
  • There is also the question of the right amount of fiscal policy. While economics does offer analysis that can help the government determine how much to change the deficit when faced with a $100 billion GDP gap, it is possible that the government will not legislate the correct amount. The economists might have been wrong in their analysis. Or the politics might have interfered. Whatever the case, if the deficit is too small, then the program may continue. If the deficit is too large, it may create other problems.