Discover the three main tools the government uses to address recessionary and inflationary economies - what economists call fiscal policy. Find out how these tools are used to help the economy in different situations.
Imagine that Sam is sick. He's at home right now, and the doctor's been called. All of a sudden, the doorbell rings, and standing at the front door is a doctor carrying a medical kit. Now, the doctor comes in the patient's bedroom, opens up the kit and finds three tools inside. I'll bet you're curious about what's in the kit, huh? The doctor chooses one or two of the tools in his toolkit and uses them on the patient.
Now imagine the patient is the whole economy. The economy has entered a slowdown that has now turned into a full-blown recession. Unemployment is high, and people are fearful of their financial future. The government uses its own fiscal policy toolkit, like a doctor, to administer fiscal policy tools - like government spending, taxes and transfer payments - to help strengthen aggregate demand when it's weak. On the other hand, when the economy is overheating by growing beyond its capacity, fiscal policy does the opposite and slows down economic growth to address the problem of inflation.
Now, the word 'fiscal' means 'budget' and refers to the government's budget. Fiscal policy, therefore, is the use of government spending, taxation and transfer payments to influence aggregate demand and, therefore, real GDP. If you imagine the government as the doctor carrying the medical kit, these three things are in the toolkit: government spending, taxes and transfer payments. Let's briefly look at some examples of each one of these fiscal policy tools.
Government spending includes the purchase of goods and services - for example, a fleet of new cars for government employees or missiles for national defense. Government spending is a fiscal policy tool because it has the power to raise or lower real GDP. By adjusting government spending, the government can influence economic output.
In addition to the primary effect of government spending on the economy, this spending multiplies through the economy as it affects businesses who sell the goods and services bought by the government. Consumers then go on to spend the paychecks they earn from those businesses, stimulating real GDP even more.
For example, when Larry's Limos receives a large order for more government vehicles, his sales increase, and he hires more employees who earn a paycheck from the company. Once they cash their paycheck, they spend this money on goods and services, and the effect of a single increase in government spending now leads to a much greater result - an effect that economists call the multiplier effect.
Alright, let's talk about taxes. Taxes are a fiscal policy tool because changes in taxes affect the average consumer's income, and changes in consumption lead to changes in real GDP. So, by adjusting taxes, the government can influence economic output. Taxes can be changed in several ways. Firstly, marginal tax rates can be raised or lowered. Secondly, they can be eliminated entirely, or the tax rules can be modified.
Alright. We've talked about government spending, then we talked about taxes - now let's talk about transfer payments. Transfer payments include things like Social Security, welfare or unemployment checks. These checks go out all over the country on a monthly basis and serve as the income for tens of millions of consumers. Transfer payments are fiscal policy tools in the same way that taxes are because changes in transfer payments lead to changes in consumer income, and when consumers spend more of their income, this influences economic output.
So, these are the three main tools that the government administers to the economy to help it in the short-term. But they can be used in two different ways. Let's find out how.
Expansionary vs. Contractionary Fiscal Policy
Each tool can be used in two opposite ways - to help expand economic output or, on the other hand, to help contract economic output, based on the diagnosis made by fiscal authorities. When the government uses fiscal policy to stimulate aggregate demand during a recession, economists call this expansionary fiscal policy.
Just imagine a small gnome wearing a government t-shirt holding a large balloon in his hand - a balloon with the words 'Real GDP' written on the side, by the way - a balloon that has become somewhat deflated. Now picture the gnome blowing up the balloon. As it expands, you can now easily read the words 'Real GDP.' This is expansionary fiscal policy because fiscal policy tools are used to expand the economy.
On the other hand, when the government uses fiscal policy to reduce aggregate demand during an inflationary economy, this is called contractionary fiscal policy. So imagine this: the small gnome is holding a large balloon that has become overinflated. It's become so big that it's about to pop. So, the gnome lets out some of the air in the balloon, which contracts it down to a more sustainable size. This is contractionary fiscal policy because fiscal policy tools are being used to contract the economy.
When the economy is growing faster than its long-term capacity, economists say that it's 'overheating' because any increase in economic output is stolen by the higher prices that inflation causes. So, they use contractionary fiscal policy to slow down the economy enough to reduce inflation.
Just like a doctor with a medical kit who treats a sick patient, the government has its own fiscal policy tools, and it uses them to treat the economy that's sick. Now you know what's inside the fiscal policy toolkit and a little bit more about how the tools are used.
Alright, it's time to review. The government uses its fiscal policy toolkit, like a doctor, to administer policies - like increased government spending, lower taxes or higher unemployment benefits - to help strengthen aggregate demand when it's weak. When the economy is overheating, on the other hand, fiscal policy does the opposite and slows down economic growth to address the problem of inflation.
The word 'fiscal' means 'budget' and refers to the government budget. Fiscal policy is therefore the use of government spending, taxation and transfer payments to influence aggregate demand. These are the three tools inside the fiscal policy toolkit.
So, when the government uses fiscal policy to stimulate aggregate demand during a recession, economists call this expansionary fiscal policy. But when the government uses fiscal policy to reduce aggregate demand during an inflationary economy, this is called contractionary fiscal policy. Two opposite things we're talking about here.
When the economy is experiencing a recession, fiscal authorities use expansionary fiscal policy by increasing government spending, lowering taxes or raising transfer payments. On the other hand, when fiscal authorities attempt to treat an overheating economy, they use contractionary fiscal policy. The tools are the same - government spending, taxes and transfer payments - but they're used in a contractionary way. That means lower government spending or higher taxes or lower transfer payments.
After viewing this lesson, you should be able to:
- Discuss government spending, taxation and transfer payments as tools in the government's fiscal policy
- Differentiate between expansionary and contractionary fiscal policies