Changes in government spending on the economy be used to close recessionary and expansionary gaps. At the same time, there are problems associated with government spending.
When the economy is in a recession, an increase in government spending can help to close the recessionary gap (that is, when real GDP is greater than potential GDP). Government spending increases aggregate demand (This increase in aggregate demand involves how government spending is creating jobs, job creation is increasing people's incomes, and an increase in incomes leads to an increase in spending.), shifting the aggregate demand curve to the right and bringing real GDP closer to potential GDP and prices will go up (1). Government spending to close a recessionary gap is known as expansionary fiscal policy (2).
Government spending can also be used to bring the economy out of a expansionary gap (that is, when potential GDP is greater than real GDP). A decrease in government spending decreases aggregate demand, shifting the aggregate demand curve to the left and bringing real GDP closer to potential GDP (3). A decrease in government spending to close an expansionary gap is known as contractionary fiscal policy (4).
The supply-side approach to government spending on the economy is to spend on things like infrustructure, capital goods, and education. This spending will cause aggregate supply, aggregate demand, and potential GDP to increase. The economy gets bigger but the gap change depends on how much aggregate supply and aggregate demand changed. The results are more uncertain with this approach. If aggregate demand is greater than aggregate supply, prices will increase. If aggregate supply is greater than aggregate demand, prices will decrease (5).
There are some problems with government spending. Firstly there are two levels of government in Canada that operating their separate fiscal policies can negate each others' effects (6). Secondly, when government spending increases and tax revenue decreases (from the government decreasing taxes and/or from people having less income to tax) , tax revenue can be more than government spending (7). In this case, a deficit is created. According to Keynes, cyclical debt caused by government running deficits during downturns in the business cycle is ok as long as the debt is paid back during the expansionary periods of the business cycle. Structural debt which is not paid back during the business cycle's upturns is not ok because of the negative effects of debt on the economy (8). However, it is difficult for government to decrease government spending and raise taxes to pay back debt because voters are resistent to such action and politicians want to be re-elected (9). Another problem with the idea of the cyclical balance budget is that it assumes the size of the business cycle's expansion equals the size of the contraction (10). Another problem is the crowding-out effect caused by the government borrowing to finance its spending. When the government borrows money, interest rates go up causing investment spending to go down and GDP to decrease (11). Finally, the lags for discretionary fiscal policy can be so long that the economy has already fixed itself by the time its starts to experience the effects of the fiscal policy (12). If aggregate demand has already gone back up, there is a risk of inflation (13).
There are four types of lags:
1) The recognition lag which is the time it takes before a problem is recognized. Statistics Canada has to conduct surveys and receive feedback. There have to be a few months of contraction before a recession can be recognized (14).
2) The decision lag which is the time between the recognition lag and the decision to act on the recognition of the problem (15).
3) The implementation lag which is the time between the decision lag and the implementation of the decision. For instance, the government has to have bids on contracts (16).
4) The impact lag (also known as the effect lag) which is the time between the implementation lag and the economy feeling the effect of the implementation. It takes time before people get their paychecks and spend more money instead of saving it (17).
Endnotes
(1) John E. Sayre and Alan J. Morris, Principles of Macroeconomics, 6th ed. (McGraw-Hill Ryerson: Toronto, 2009), 389.
(2) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(3) John E. Sayre and Alan J. Morris, Principles of Macroeconomics, 6th ed. (McGraw-Hill Ryerson: Toronto, 2009), 389.
(4) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(5) Ibid.
(6) Ibid.
(7) Ibid.
(8) Ibid.
(9) Ibid.
(10) Dr. Stephanie Powers, Fiscal Policy Debt (presented at Red Deer College, April 9, 2012).
(11) Ibid.
(12) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(13) Ibid.
(14) Ibid.
(15) Ibid.
(16) Ibid.
(17) Ibid.
1. expansionary Fiscal policy
2. Contrctionary fiscal policy
3. Supply side fiscal policy
Changes in government spending on the economy be used to close recessionary and expansionary gaps. At the same time, there are problems associated with government spending.
When the economy is in a recession, an increase in government spending can help to close the recessionary gap (that is, when real GDP is greater than potential GDP). Government spending increases aggregate demand (This increase in aggregate demand involves how government spending is creating jobs, job creation is increasing people's incomes, and an increase in incomes leads to an increase in spending.), shifting the aggregate demand curve to the right and bringing real GDP closer to potential GDP and prices will go up (1). Government spending to close a recessionary gap is known as expansionary fiscal policy (2).
Government spending can also be used to bring the economy out of a expansionary gap (that is, when potential GDP is greater than real GDP). A decrease in government spending decreases aggregate demand, shifting the aggregate demand curve to the left and bringing real GDP closer to potential GDP (3). A decrease in government spending to close an expansionary gap is known as contractionary fiscal policy (4).
The supply-side approach to government spending on the economy is to spend on things like infrustructure, capital goods, and education. This spending will cause aggregate supply, aggregate demand, and potential GDP to increase. The economy gets bigger but the gap change depends on how much aggregate supply and aggregate demand changed. The results are more uncertain with this approach. If aggregate demand is greater than aggregate supply, prices will increase. If aggregate supply is greater than aggregate demand, prices will decrease (5).
There are some problems with government spending. Firstly there are two levels of government in Canada that operating their separate fiscal policies can negate each others' effects (6). Secondly, when government spending increases and tax revenue decreases (from the government decreasing taxes and/or from people having less income to tax) , tax revenue can be more than government spending (7). In this case, a deficit is created. According to Keynes, cyclical debt caused by government running deficits during downturns in the business cycle is ok as long as the debt is paid back during the expansionary periods of the business cycle. Structural debt which is not paid back during the business cycle's upturns is not ok because of the negative effects of debt on the economy (8). However, it is difficult for government to decrease government spending and raise taxes to pay back debt because voters are resistent to such action and politicians want to be re-elected (9). Another problem with the idea of the cyclical balance budget is that it assumes the size of the business cycle's expansion equals the size of the contraction (10). Another problem is the crowding-out effect caused by the government borrowing to finance its spending. When the government borrows money, interest rates go up causing investment spending to go down and GDP to decrease (11). Finally, the lags for discretionary fiscal policy can be so long that the economy has already fixed itself by the time its starts to experience the effects of the fiscal policy (12). If aggregate demand has already gone back up, there is a risk of inflation (13).
There are four types of lags:
1) The recognition lag which is the time it takes before a problem is recognized. Statistics Canada has to conduct surveys and receive feedback. There have to be a few months of contraction before a recession can be recognized (14).
2) The decision lag which is the time between the recognition lag and the decision to act on the recognition of the problem (15).
3) The implementation lag which is the time between the decision lag and the implementation of the decision. For instance, the government has to have bids on contracts (16).
4) The impact lag (also known as the effect lag) which is the time between the implementation lag and the economy feeling the effect of the implementation. It takes time before people get their paychecks and spend more money instead of saving it (17).
Endnotes
(1) John E. Sayre and Alan J. Morris, Principles of Macroeconomics, 6th ed. (McGraw-Hill Ryerson: Toronto, 2009), 389.
(2) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(3) John E. Sayre and Alan J. Morris, Principles of Macroeconomics, 6th ed. (McGraw-Hill Ryerson: Toronto, 2009), 389.
(4) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(5) Ibid.
(6) Ibid.
(7) Ibid.
(8) Ibid.
(9) Ibid.
(10) Dr. Stephanie Powers, Fiscal Policy Debt (presented at Red Deer College, April 9, 2012).
(11) Ibid.
(12) Dr. Stephanie Powers, Fiscal Policy (presented at Red Deer College, April 4, 2012).
(13) Ibid.
(14) Ibid.
(15) Ibid.
(16) Ibid.
(17) Ibid.