Fiscal Policy Actions in the Short Run

Imagine this scenario: the stock market is plummeting, unemployment is rising, and businesses are closing left and right. What is the proper stabilization policy that the U.S. should use during these times? The answer is both fiscal and monetary policy. In this article, we will be particularly looking at how fiscal policy actions in the short run are used and what their effects are. Ready to explore? Then let's dive in!

Fiscal Policy Actions in the Short Run Explanation

Let's try to explain some fiscal policy actions in the short run. Fiscal policy is done by the government and alters spending and taxes. The state of the economy will dictate policy actions. A recessionary period will call for higher government spending and lower taxes (expansionary fiscal policy), whereas an inflationary period will call for lower government spending and higher taxes (contractionary fiscal policy). These tools are used to alter aggregate demand in an economy to reach equilibrium. But how exactly do government spending and taxes affect aggregate demand in the short run?

The answer is: through disposable income.

Let's see how disposable income is calculated:

$DisposableIncome=PersonalIncome+GovernmentTransfers-Taxes$

$DisposableIncome=PersonalIncome+GovernmentTransfers-Taxes$

Fiscal policy will directly affect government transfers (through government spending) and taxes. An increase in government transfers (or decrease in taxes) will increase disposable income — this will lead to an increase in consumer spending. Alternatively, an increase in taxes (or decrease in transfers) will decrease disposable income — this will lead to a decrease in consumer spending. As we can see, fiscal policies will affect the disposable income of individuals to shift the aggregate demand.

Examples of Fiscal Policy Actions in the Short Run

Let's take a look at some examples of how fiscal policy actions in the short run affect aggregate demand.

Expansionary Fiscal Policy Actions in the Short Run: Graph and Formula

What can we say about the economy in the graph below? Initially, at P1 and Y1, the government is in a recessionary period. We know this since the aggregate demand (AD1) and short-run aggregate supply (SRAS1) intersect below equilibrium (equilibrium can be found at P2 and Y2). The recession will cause the government to spend more and tax less to increase aggregate demand in the short run. The result is an increase in output (from Y1 to Y2) and price level (from P1 to P2) to reach equilibrium. The government's decision to increase government spending and decrease taxes to stimulate the economy is known as Expansionary Fiscal Policy.

Fig 1. - Expansionary Fiscal Policy

Contractionary Fiscal Policy Actions in the Short Run: Graph and Formula

What can we say about the economy in the graph below? Initially, at P1 and Y1, the economy is in an inflationary period. We know this since the aggregate demand (AD1) and short-run aggregate supply (SRAS1) curves intersect above equilibrium (equilibrium can be found at P2 and Y2). Inflation will cause the government to spend less and increase taxes to decrease aggregate demand in the short run. The result is a decrease in output (from Y1 to Y2) and price level (from P1 to P2) to reach equilibrium. The government's decision to decrease government spending and increase taxes to depress the economy is known as Contractionary Fiscal Policy.

Fig 2. - Contractionary Fiscal Policy

Impacts of Fiscal Policy Actions on Output

Understanding how fiscal policy actions impact consumer demand in the short run will also help us understand how the output changes. After all, the output is what needs to change for fiscal policy to be effective. We will look at how two policy actions change output in an economy: government spending and taxes.

Impacts of Fiscal Policy Actions in the Short Run on Output: Government Spending

How much will the output change if the government decides to spend 100 billion dollars? You may recall the spending multiplier effect, which tells us how much a change in spending will change output with the following formula: $Spendingmultiplier=\frac{1}{1-MPC}$

Let's take a look at a brief example:

For every dollar the government spends, the change in real GDP (output) will increase by 2. Taking our initial government spending of 100 billion dollars, the increase in output will actually be 200 billion dollars — a big increase! But why does this matter?

Governments need to know the exact number that they predict output will change by. If a government overspends, then they risk pushing the economy from a recessionary period to an inflationary one. By utilizing the spending multiplier, governments are equipped to make proper changes in government spending to reach their desired output.

Impacts of Fiscal Policy Actions in the Short Run on Output: Taxes

A change in taxes will also change output by some amount — it is very similar to the example above!

To find the change in output, we will need to utilize the tax multiplier formula:

$Taxmultiplier=-\frac{MPC}{MPS}$

The government's desired output is divided by the tax multiplier to obtain the change in taxes that needs to be made. Let's look at a brief example:

Fiscal policy provides great benefits to an economy when used properly, but there are some disadvantages of Fiscal policy actions in the short run. Let's explore some of the potential drawbacks to this stabilization policy.

Disadvantages of Fiscal Policy Actions in the Short Run: Time Lag

The unfortunate reality of fiscal policy action is that there are significant time lags. Economic data can take a long time to analyze to determine the current state of the economy. The legislative branch is purposely deliberative which can add to the time needed to pass any type of fiscal policy. Finally, the spending that the government decides to pass will take some time to be noticed in an economy. A government spending 10 billion dollars on new roads will not be seen the day it is passed in congress — it takes a long time to build roads!

The problem with these time lags is that the recessionary or inflationary gap may be solved on its own prior to any fiscal policy actions being implemented. What follows is fiscal policy actions being implemented after an economy has already recovered. Imagine trying to fix a recession in your economy, but because of time lags, you took too long to react, and now the economy is in equilibrium. The danger is that now you will overheat the economy and push it into an inflationary gap.

Disadvantages of Fiscal Policy Actions in the Short Run: Supply Shocks

As much as a government can prepare to implement fiscal policy action with the utmost precision, it still may not be effective. We know how governments respond to demand shocks, but what can they do about supply shocks?

A supply shock will cause stagflation, an increase in unemployment and inflation. A government can either decrease or increase aggregate demand in response to a supply shock. An increase in aggregate demand (expansionary fiscal policy) will cause prices to rise even higher but will control unemployment. A decrease in aggregate demand (contractionary fiscal policy) will cause unemployment to worsen but will control inflation. As you can see, this makes it difficult to address supply shocks with fiscal policy action — there is no right answer.

Application of Fiscal Policy in the Short Run

Let's take a look at real-life applications of fiscal policy actions to see the rationale behind the government's decision-making.

Application of Expansionary Fiscal Policy in the Short Run

The Great Recession of 2008 saw a stimulus action that was not very effective. It gave low-income Americans a $600 rebate for non-married individuals and $1,200 for married couples.¹ Modest transfer payments and tax cuts were also done with these rebates. Economists believed that the multiplier was too low to increase aggregate demand by the desired amount. In the summer of 2008, it was clear that these measures were not effective enough in fighting this recession.

The American Recovery and Reinvestment Act was passed in February of 2009 — a much larger stimulus measure than the previous one. $787 billion went to investing in infrastructure, tax cuts, and helping the unemployed.² This stimulus package aimed to right the wrongs of the previous one by increasing spending by a larger amount to offset the low multiplier.

Application of Contractionary Fiscal Policy in the Short Run

In 1968, policymakers were worried about rising inflation — The Vietnam War was incessant without any sign of stopping. Lyndon B. Johnson chose to send more troops and weapons to Vietnam; government spending inevitably grew to accommodate Lyndon B. Johnson's ambitions.³ What might be the economic outcome of this action? How might Lyndon B. Johnson's administration handle this outcome?

The economic outcome that could arise from increasing government spending is inflation. The solution was to apply a contractionary fiscal policy action. Lyndon B Johnson's administration increased taxes by 10%⁴ and decreased government spending. Both of these measures were done in response to high government spending to fund the Vietnam War. Lyndon B. Johnson's administration recognized that increasing government spending had to be offset with a contractionary fiscal policy. Without doing so, aggregate demand would have increased too much, resulting in inflation.

As you can see, fiscal policy actions in the short run are taken into account at the federal level. Influencing aggregate demand through fiscal policy is a powerful tool that the government has. It can get them through recessions (The American Recovery and Reinvestment Act), prevent inflation (Lyndon B. Johnson's tax surcharge), and overall stabilize any fluctuations in the economy.