How To Get Out Of A Recession Using Fiscal Policy?

The use of government spending and tax policies to impact economic circumstances is referred to as fiscal policy.
Fiscal policy is largely founded on the views of John Maynard Keynes, who claimed that governments could regulate economic activity and stabilize the business cycle.
During a recession, the government may use expansionary fiscal policy to boost aggregate demand and boost economic growth by decreasing tax rates.
A government may follow a contractionary fiscal strategy in the face of rising inflation and other expansionary signs.

How does fiscal expansion help to close a recessionary gap?

By altering aggregate expenditures and bending the aggregate demand curve, expansionary fiscal policy aims to close a recessionary gap. A rightward shift of the aggregate demand curve closes a recessionary gap.

How does fiscal policy help to keep the economy stable?

During an economic slump, fiscal policy can help to maintain aggregate demand and private sector incomes, while also reducing economic activity during periods of robust expansion.

The so-called “automatic fiscal stabilisers” play a significant role in fiscal policy stabilization. These take into account the impact of economic swings on the government budget and do not need policymakers to make any short-term decisions. For example, the quantity of tax collections and transfer payments is closely related to the economy’s cyclical situation and adjusts in a way that helps stabilize aggregate demand and private sector incomes. Automatic stabilizers have a variety of appealing characteristics. First and foremost, they respond in a predictable and timely manner. This makes it easier for economic agents to create accurate expectations and boosts their confidence. Second, they react with a level of intensity that is proportional to the magnitude of the economic divergence from what was anticipated when budget plans were authorized. Third, automatic stabilizers work in a symmetrical manner throughout the economic cycle, preventing overheating during booms and boosting economic activity during downturns without jeopardizing the underlying integrity of budgetary positions as long as fluctuations are balanced.

Stabilization can theoretically also be achieved by discretionary fiscal policy, in which governments actively choose to modify spending or taxes in response to fluctuations in economic activity. However, as previous attempts to manage aggregate demand using discretionary fiscal measures have frequently proved, discretionary fiscal policies are not typically suitable for demand management. First, discretionary policies can jeopardize the fiscal health of governments, since it is simpler for governments to lower taxes and increase expenditure during periods of low growth than it is to do the opposite during periods of high growth. As a result, the public debt and tax burden are likely to continue to rise. As a result, high taxes may have a negative impact on the economy’s long-term growth prospects, as they limit incentives to labor, invest, and innovate. Second, many of the positive characteristics of automatic stabilizers are nearly impossible to mimic by policymakers’ discretionary reactions. Tax adjustments, for example, must usually be approved by Parliament, and their implementation typically lags behind the budget-setting process. As a result, discretionary fiscal measures aimed at managing aggregate demand have historically tended to be pro-cyclical, frequently becoming effective after cyclical conditions have already reversed, worsening macroeconomic swings.

Clearly, fiscal policy’s short-term stabilizing function is especially crucial for nations that are members of a monetary union, because nominal interest rates and exchange rates do not adapt to the condition of a single country, but rather to the union’s overall position. Fiscal policy, which remains in the hands of individual governments, can then become a critical tool for stabilizing domestic demand and output. At the same hand, when there is more uncertainty about future income trends, the restrictions of active fiscal policy may be larger. This is the case in many European countries today, where public pension and health-care systems are facing increasing difficulties as a result of demographic trends. In these circumstances, today’s cyclically-oriented tax cuts and spending increases may simply result in greater taxes or reduced spending tomorrow. With this in mind, the public may respond to fiscal increases by boosting precautionary savings rather than consumption.

What is the scope for discretionary fiscal policy in light of the previous discussion? Discretionary policies are required to execute long-term structural changes in public finances as well as to cope with exceptional circumstances, such as when the economy is subjected to extreme shocks. Discretionary policies, in reality, reflect shifting preferences on the size of the government that is desirable, the priorities of public spending, and the quantity and characteristics of taxation. These policies shape the structure of government finances and have a significant impact on the economy’s performance, as well as the characteristics of a country’s automatic stabilizers. Discretionary fiscal policy decisions are also required to ensure the medium-term viability of governmental finances. This is a requirement for automatic stabilisers to function freely, as fiscal policy can only function as an effective stabilizing tool if there is sufficient room for maneuvering.

The experience of industrialised countries over the last few decades clearly demonstrates that persistent budget imbalances hinder fiscal policy’s ability to stabilize the economy. During downturns, imbalances frequently demand stringent fiscal policies to avoid unsustainable deficits and debt growth. As a result, when the economy’s long-term viability is in question, expansionary policies and even automatic stabilizers may not have the desired effect on output as people modify their behavior. Consolidation actions may then re-establish confidence and raise expectations about the public finances’ long-term prospects. These ‘non-Keynesian’ consequences may have the unintended consequence of fiscal consolidation having an expansionary influence on the economy. When budgetary circumstances are seen to be risky or when fiscal sustainability is threatened by excessive debt and future fiscal obligations, active fiscal consolidation with discretionary actions is appropriate. Finally, while automatic fiscal stabilisers are excellent at mitigating regular cyclical variations, there may be times when active policy actions are required. When economic imbalances do not come from normal cyclical conditions or are regarded irreversible, automatic stabilisers alone may not be adequate to stabilize the economy. However, in a recession, the benefits of expansionary measures must be weighed against the dangers of long-term sustainability or long-term negative consequences on the structure of government finances, such as a permanently higher tax rate, as well as the economic costs of reversing policy.

How does a recessionary economy recover?

A drop in demand within the economy whether from businesses, consumers, the government, or other countries is the primary cause of an economic recession. As a result, the most effective response will be determined by the recession’s core cause.

If consumer spending is down, it might be a good idea to lower taxes. This will provide them with additional cash and encourage increased economic spending. A slowdown in corporate investment, on the other hand, may necessitate lower interest rates in order to reduce debt burdens.

Reduce Taxes

When governments lower taxes, they frequently do so at the expense of increasing the budget deficit. The government obtains fewer tax revenues but maintains the same level of spending, giving the economy a benefit overall. While this raises the budget deficit, it also increases the amount of money in the hands of the typical consumer.

How could the federal government utilise fiscal policy to help the economy recover faster?

The government can reduce fiscal stimulus by raising taxes, cutting spending, or doing both at the same time. Individuals have less disposable income when the government hikes individual income taxes, for example, and spend less on goods and services as a result.

How can you close the expansionary gap?

To repair the gap and enhance real GDP, policymakers may choose to undertake a stabilization policy (expansionary policy). By decreasing interest rates and increasing government spending, monetary authorities may be able to increase the amount of money in circulation in the economy.

How does fiscal policy help to alleviate stagflation?

Stagflation occurs when inflation rises while output falls and unemployment rises.
Stagflaton is a period when salaries are unable to keep up with rising prices, resulting in real income declines.
A rise in the price of commodities, such as oil, is a common source of stagflation. After the price of oil tripled in the 1970s, stagflation developed.
Following the surge in oil prices and the commencement of the global crisis in 2008, there was some stagflation.
Policymakers have a difficult time dealing with stagflation. The Central Bank, for example, can raise interest rates to lower inflation or lower interest rates to lower unemployment. However, they will be unable to address both inflation and unemployment at the same time.

Causes of stagflation

The price of oil is rising. A supply-side shock is frequently the source of stagflation. For example, rising commodity prices, such as oil prices, will raise company costs (making transportation more expensive) and move short-term aggregate supply to the left. As a result, inflation rises and GDP falls.
Trade unions with clout. If trade unions have considerable bargaining power, they may be able to negotiate for greater salaries even while the economy is slowing. Inflation is largely caused by rising salaries.
Productivity is decreasing. When an economy’s productivity falls, workers become more inefficient, costs rise, and output falls.
Unemployment is increasing structurally. If established industries collapse, we may see more structural unemployment and decreased output. As a result, even if inflation rises, we may see more unemployment.
Shocks in supply. In the event that supply chains are disrupted, prices will begin to rise. Unemployment will fall as a result of the supply shock. For example, supply disruptions in the United Kingdom triggered moderate stagflation in 2021.

Moderate stagflation

When inflation rises as the growth rate falls (i.e. the economy grows at a slower pace), this is referred to as stagflation. Higher inflation and negative growth are less destructive. However, it still implies a deterioration in the unemployment-inflation trade-off.

Stagflation and Phillips Curve

According to the classic Phillips curve, there is a trade-off between inflation and unemployment. Stagflation causes the Phillips curve to shift to the right, resulting in a worse trade-off.

Stagflation (greater inflation and higher unemployment) is shown by the Phillips curve shifting to the right.

Stagflation in the 1970s

In 1974, we had a 25% increase in inflation while experiencing negative GDP growth. The increase in oil prices, as well as the end of the Barber Boom, contributed to this.

This illustrates how the US economy faced a tougher trade-off in the 1970s, with higher inflation and unemployment. The Phillips Curve was slanting rightward.

Stagflation in 2010/11

In 2011, inflation in the United Kingdom increased to 5%, but the economy remained in a state of depression, with negative or very poor growth.

Higher taxes have the effect of increasing inflation while lowering living standards.

Solutions to stagflation

In general, monetary policy can aim to lower inflation (through higher interest rates) or boost economic growth (via lower interest rates) (cut interest rates). Inflation and recession cannot be solved by monetary policy at the same time.
Reducing the economy’s reliance on oil is one way to make it less susceptible to stagflation. Stagflation is mostly caused by rising oil costs.
The only real solution is to boost productivity through supply-side measures, which allows for stronger growth without inflation. Stagflation Solutions can be found here.
The Central Bank opted to maintain interest rates low (at 0.5 percent) in 2010/11 because they believed that sluggish growth was a bigger problem than modest cost-push inflation.

Misery index

Unemployment plus inflation equals the misery index. Stagflation causes both unemployment and inflation to grow, hence a high misery index implies a stagflationary time. As a result of high unemployment and inflation, the UK had a misery index of around 14 percent in 2012.

Stagflation of the 1970s

The United States saw a substantial surge in inflation in the 1970s as a result of rising oil costs.

As the postwar economic boom stalled, inflation led to a rise in unemployment.

The Keynesian consensus of the postwar period was questioned. Until the 1970s, the government and the Federal Reserve seemed to be able to control the economic cycle. However, in the 1970s, both unemployment and inflation increased, and it appeared that traditional fiscal and monetary policy could not handle the dual problems.
The economic issues of the 1970s gave rise to monetarists like Milton Friedman, and in the early 1980s, the UK and US implemented monetarist policies with the primary goal of reducing inflation while ignoring the short-term consequences of unemployment.

A return to Stagflation

Global inflation is expected to rise in 2022 as a result of supply side shocks, rising oil prices, and supply chains reacting to Covid shocks. However, when the economy recovers from the Covid downturn, we are seeing strong growth (e.g., the UK grew 7.1 percent in 2021).

The economic growth figures, on the other hand, are a little deceiving. Because real earnings have been squeezed by rising prices, most consumers do not believe there is 7.1 percent ‘growth.’ As a result, even if economic statistics do not reveal classic stagflation, it may seem like stagflation to many consumers.

What are the four most significant fiscal policy limitations?

Other fiscal policy constraints include widespread underemployment, a lack of public coordination, tax evasion, and a small tax base.

That monetary and fiscal policymakers should try to stabilise the economy

Pro: Policymakers should work to keep the economy stable. Household and business pessimism lowers aggregate demand and leads to recession. It is a waste of resources to reduce output and create unemployment as a result of this. This waste of resources is unnecessary because the government can lean against the wind and stabilize aggregate demand by raising government expenditure, lowering taxes, and expanding the money supply. These policies can be overturned if aggregate demand is too high.

Negative: Policymakers should avoid attempting to stabilize the economy. The economy is affected by monetary and fiscal policy with a significant lag. Interest rates are influenced by monetary policy, which might take six months or longer to have an impact on household and commercial investment spending. A long political process is required to modify fiscal policy. Due to the difficulty of forecasting and the unpredictable nature of many shocks, stabilization policy must be based on educated assumptions about future economic situations. Activist policy can become destabilizing as a result of mistakes. The primary guideline of policymaking should be to “do no harm,” hence policymakers should avoid engaging in the economy frequently.

That monetary policy should be made by rule rather than discretion

The Reserve Bank Board meets every month to decide if any adjustments to its monetary policy stance are required, based on assessments and estimates of future economic conditions. Every month, the RBA declares whether the cash rate will rise, fall, or stay the same. At the moment, the RBA has practically total discretion over monetary policy.

Pro: Monetary policy should be governed by a set of rules. Discretionary policy has two major drawbacks.

First, discretionary policy does not protect against ineptitude and power abuse. When a central bank manipulates monetary policy to benefit a certain political candidate, it is abusing its power. It can boost the money supply before an election to help the incumbent, and the inflation that results does not show up until after the election. The political business cycle is the result of this.
Second, due to policy inconsistency over time, discretionary policy may result in higher inflation than desired. This happens because policymakers are inclined to set a low inflation target, but once people have formed their inflation expectations, authorities can use the short-run trade-off between inflation and unemployment to raise inflation and reduce unemployment. As a result, individuals predict higher inflation than officials claim, pushing the Phillips curve upward and making it less favorable.

By committing the central bank to a policy norm, these issues can be avoided. Parliament may mandate that the RBA expand the money supply by a specific percentage each year, say 3%, just enough to keep pace with actual output growth. Alternatively, lawmakers might impose a more proactive rule, requiring the RBA to respond with a particular increase in the money supply if unemployment rises above a certain percentage point above the natural rate.

Cons: Monetary policy should not be determined by a set of rules. Because monetary policy must be flexible enough to respond to unforeseen occurrences like a major drop in aggregate demand or a negative supply shock, discretionary monetary policy is required. Furthermore, if a central bank’s declarations are credible, political business cycles may not occur and time-inconsistency issues may be avoided. Finally, it is unclear what form of rule parliament should impose if monetary policy is to be governed by a rule.

That the central bank should aim for zero inflation

Pro: Inflation should be kept at zero by the central bank. Inflation has the following consequences for society:

The expenses of achieving zero inflation are transient, whereas the advantages of low inflation are permanent. If a credible zero-inflation policy is declared, costs can be further decreased. If lawmakers made price stability the RBA’s principal purpose, the policy would be more credible. Finally, the only non-arbitrary aim for inflation is zero. All other target levels can be raised in small increments.

Cons: Inflation should not be aimed at zero by the central bank. The central bank should not aim for zero inflation for a variety of reasons:

The benefits of obtaining zero inflation are minor and unpredictable, while the drawbacks of doing so are substantial. Remember that the sacrifice ratio is estimated to be 5% of a year’s output for a 1% reduction in inflation.
The unskilled and inexperienced – those least able to afford it – bear the brunt of the unemployment and social expenses connected with the fall in inflation.
People oppose inflation because they incorrectly believe it lowers their living standards, whereas inflation actually raises incomes.
By indexing the tax system and issuing inflation-indexed government bonds, many of the expenses of inflation can be reduced without lowering inflation.
Because the capital stock is lower and the unemployed workers’ skills are weakened, disinflation leaves enduring scars on the economy.

That the government should balance its budget

Pro: The government’s budget should be balanced. Future generations of taxpayers will be burdened by the government’s debt, which will force them to choose between paying greater taxes, cutting government spending, or doing both. The bill for current spending is passed on to future taxpayers by current taxpayers. Furthermore, a deficit has the macroeconomic consequence of reducing national savings by making public savings negative. As a result, interest rates rise, capital investment falls, productivity and real wages fall, and future output and income fall. Deficits boost future taxes and lower future incomes as a result. During wars and recessions, however, a budget deficit is justified.

Cons: The government’s budget should not be balanced. The government debt crisis is overblown. When compared to predicted lifetime earnings of $1 000 000, the national debt of $1130 per individual is insignificant. It is not always beneficial to reduce government spending. Reducing the fiscal deficit by cutting education spending, for example, may not benefit the wellbeing of future generations. Other government measures, such as welfare benefits, redistribute income across generations. People who want to reverse the intergenerational income redistribution caused by budget deficits simply need to save more during their lifetime (thanks to lower taxes) and leave bequests to their children to cover the higher taxes. Finally, government debt can expand indefinitely without increasing as a percentage of GDP as long as it does not grow faster than the nation’s nominal revenue. Government debt in Australia can expand at a rate of roughly 6% per year without increasing the debt-to-income ratio. Recent budget surpluses have aided in the reduction of overall government debt.

That the tax laws should be reformed to encourage saving

Pro: Tax laws should be changed to encourage people to save. The standard of living of a country is determined by its productive capacity, which is determined by how much it saves and invests. Because individuals respond to incentives, the government could encourage people to save (or discourage them from saving) by:

lowering means-tested government programs such welfare, old-age pensions, and youth allowance These advantages are currently lowered for people who have saved prudently, creating a disincentive to save.
Some types of retirement savings are already eligible for tax breaks. Households may have more opportunities to use tax-advantaged savings accounts.
Consumption taxes, such as the GST, encourage people to save more than income taxes.

Contrary to popular belief, tax regulations should not be changed to encourage saving. One of the goals of taxation is to disperse the burden of revenue fairly. By lowering saving taxes, all of the aforementioned solutions will boost the incentive to save. Because high-income people save more than low-income people, the tax burden on the poor will rise. Furthermore, saving may not be sensitive to changes in the rate of return on saving, thus lowering saving taxes will only benefit the wealthy. This is due to the fact that a greater rate of return on savings has both a substitution and an income effect. As consumers substitute saving for current consumption, an increase in the return to saving will increase saving. The income effect, on the other hand, argues that increasing the return to saving reduces the quantity of saving required to reach any desired level of future consumption.

A decrease in the deficit boosts public savings and, as a result, national savings. Raising taxes on the wealthy could help achieve this. Indeed, decreases in saving taxes may have the unintended consequence of raising the deficit and decreasing national savings.

What role does fiscal policy play in stimulating demand?

The term “expansionary fiscal policy” is defined as “fiscal policy that is designed The government is attempting to stimulate aggregate demand by increasing government expenditure and/or lowering taxes.

Increased government borrowing and the sale of bonds to the private sector are typically used to fund expansionary fiscal policy.

When there is unemployment, surplus savings, and falling real output, Keynes believes that expansionary fiscal policy should be adopted. He maintained that by increasing government spending, the economy would be stimulated and jobless resources would be put back to work. This allows the economy to recover faster than if it were left to its own devices.

How expansionary fiscal policy works

If the government lowers income taxes, consumers will have more discretionary money and will be able to spend more. Higher consumption will boost aggregate demand, resulting in faster economic development.

Alternatively, if the government expanded its investment in public works programs, this would result in more jobs, higher salaries, and more aggregate demand.

This influx of cash into the economy has the potential to have a positive multiplier effect. Builders who get a job, for example, will spend more money elsewhere in the economy to create other jobs. The end gain in real GDP from the government’s first injection will be greater than the initial investment.

Because of the increased demand in the economy, expansionary fiscal policy can also lead to inflation.

Paradox of thrift

One argument for fiscal policy is that the government should spend more to compensate for increased private sector saving and decreased private sector spending.

As consumers cut back on spending at the outset of the recession in 2009, the saving ratio increased quickly. This resulted in a decrease in demand. This increase in saving can be used by fiscal policy to increase spending.

Expansionary fiscal policy and government borrowing

Expansionary fiscal policy may have the unintended consequence of increasing the size of a government’s budget deficit.

Financial suffocation. Increased deficits could frighten investors, causing interest rates on government debt to rise. (This occurred in the Eurozone without the Central Bank purchasing bonds, while bond yields decreased in the United Kingdom and the United States due to robust demand for bonds.)
Overcrowding of resources. When private investors buy government bonds, they have less money to invest in the private sector.

Evaluation of expansionary fiscal policy

1. Is there anything else going on in the economy?

Lowering income taxes may not be enough to improve AD if house prices are declining and confidence is low.
In 2008, for example, the United States attempted to slash taxes in the hopes of increasing spending. However, the economy was also suffering from declining home values, a lack of confidence, and a credit scarcity; as a result of all of these issues, expansionary fiscal policy proved ineffectual in encouraging quick economic growth.

2. Overcrowding

When the government spends more, but borrows from the private sector, the private sector invests less, and government expenditure ‘crowds out’ private sector spending.
Private saving rates, on the other hand, climb rapidly during a liquidity trap/recession. As a result, expansionary fiscal policy serves to counteract the increase in private sector saving, injecting money into the circular flow while avoiding crowding out.

3. Fiscal policy timing – the amount of spare capacity

The state of the economy is a major concern of expansionary fiscal policy. Increased government borrowing is likely to produce crowding out and/or lead to higher inflation if expansionary fiscal policy is undertaken while the economy is close to full capacity (e.g. AD3 to AD4). However, there will be minimal rise in real GDP.
In a deep recession, when the economy has spare capacity, expansionary fiscal policy will not result in crowding out or inflation. (From Y1 to Y2, real GDP rises due to AD1 to AD2.)

Supply side effects of fiscal policy

Increased government spending on education and training could boost long-term labor productivity and help the economy grow at its long-term trend rate.
Government spending, on the other hand, could be inefficient and wasteful, depending on what the government spends the extra money on.

Automatic vs Discretionary fiscal policy

Fiscal stabilizers that work on their own. The government will automatically spend more on jobless compensation during a recession (because more people will be unemployed). People also pay less income tax during a recession (because they earn less)
Fiscal stabilizers with discretion. This happens when the government raises or lowers tax rates or spends more or less money.

Different views on fiscal policy

When there is an increase in demand-deficient unemployment and surplus savings, Keynesians say that fiscal policy should be adopted. If the economy is below full capacity, Keynesians maintain, there will be no crowding out.
Monetarists are more critical of fiscal policy, believing that increased government borrowing will lead to crowding out, as increased government expenditure will only lead to a decrease in private sector spending.
Theoretical Economics in the Twenty-First Century (MMT). This argument claims that printing money can be used to fund expansionary fiscal policy as long as inflation stays within a reasonable range.
Equivalence in Ricardian terms. This argument claims that expansionary fiscal policy does not result in an increase in demand because consumers expect taxes to rise in the future to pay off the increased government debt.

In a downturn, how can you boost economic growth?

During recessions, economic stimulus is frequently used. Lowering interest rates, increasing government expenditure, and quantitative easing, to mention a few, are all common policy strategies used to achieve economic stimulation.