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Tuesday, January 08, 2008
Fiscal Policy in Response to Economic Downturns, Pt. 1: What is Fiscal Policy and Why Use It?
On Friday of last week (January 4), the Bureau of Labor Statistics released December employment data showing that the unemployment rate had jumped from 4.7 percent to 5.0 percent, causing many economists to predict a higher probability of recession in the coming quarters. Attention is now focused on policy makers in anticipation of an offering of some sort fiscal policy response.
This series will lay out the basic mechanics of fiscal policy in response to economic downturns.
When economic growth slows considerably, or even contracts, firms respond by cutting back production of goods and services. And since less labor is required by these firms to maintain the new level of output, firms will either reduce the size of their labor pool by laying off workers (or by reducing the number of hours of paid work or some combination of both). In short, many people will see a reduction in income during economic downturns.
The federal government can ease the hardship of unemployment and lower incomes through fiscal policy - that is by changing rates of taxation or the amount of money spent by the federal government. The purpose of this fiscal policy response response is to cushion the blow of a slumping economy along two dimensions: 1) the duration of a recession and 2) the magnitude of the hardship faced by families who experience job loss or a significant decreases in income.
The mechanism by which (1) is accomplished is by increasing aggregate demand. When the government either reduces taxes or increases spending, it stimulates economic activity by injecting money into the economy thus increasing demand for goods and services (people have more money to spend on stuff). Firms respond to this increased demand my expanding production of goods and services and thus increasing their labor pool.
The second dimension is affected simply by putting money into the hands of the people who are hit hardest by the economic downturn. A reduction in taxes or increasing spending through, say, unemployment insurance or food stamps allows individuals to continue buying food, housing, and medicine. And the more effective fiscal policy is at meeting objective (2), the more successful it will be in meeting objective (1).
In Part 2 of this series I will discuss The Multiplier Process.
Posted by Craig Jennings
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