Question

a) Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP.

b) Do you think the typical time lag for fiscal policy is likely to be longer or shorter than the time lag for monetary policy? Explain your answer

c) How would a balanced budget amendment change the effect of automatic stabilizer programs?

d) What would happen if contractionary fiscal policy were implemented during an economic boom but, due

to lag, it did not take effect until the economy slipped into recession?

Answer 1

a) In a recession, the tax deduction will automatically accrue as incomes are low and earnings are low. Many welfare and unemployment programs are designed to help those who are eligible in certain categories, such as "unemployed" or "low income." During the recession, more people fall into these categories and automatically qualify for benefits. The combination of low taxes and high costs requires the economy to produce less than GDP in a recession. With economic growth, the average income level in the economy increases, so more taxes are automatically charged. Fewer people have the criteria to obtain government assistance for the unemployed or the poor, so government spending for unemployment assistance and welfare will automatically decrease. A high tax and low cost economy will only produce a higher economy than GDP.

b) Monetary policy may have a shorter duration than fiscal policy. Assume that the data is clear that the economy is in or near recession. The Federal Reserve's Open Market Committee meets six times a year and the broader economic policy can be implemented through open market operations. In addition, monetary policy is enforced by interest rates, which change very quickly. However, the fiscal policy is implemented through congressional work, which requires the president to sign legislation. It often takes months to discuss such laws, and after negotiating laws, spending programs or tax cuts take longer to affect the macroeconomy.

c) In programs in which the amount of spending is not fixed, but it is rather determined by macroeconomic conditions, like food stamps, would actually lose a great deal of flexibility if spending increases. It had to be met by corresponding tax increases or spending cuts.

d) Here the employment would suffer as a result of too little spending.