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 Fiscal Policy Actions in the Short Run

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Table of contents

    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:

    Disposable Income = Personal Income + Government Transfers - Taxes

    Disposable Income = Personal Income + Government Transfers - 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.

    Disposable Income is the income left over after tax deductions and government transfers.

    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.

    Fiscal Policy Actions in the Short Run Expansionary Fiscal Policy Study Smarter OriginalsFig 1. - Expansionary Fiscal Policy

    Expansionary Fiscal Policy occurs when the government increases spending and/or decreases taxes to increase aggregate demand.

    We can view the same example with the disposable income formula:

    Disposable Income ($40,000) ==Personal Income ($50,000) + Government Transfers ($0) - Taxes ($10,000)

    Your disposable income in this instance is $40,000. But what if the government implements an expansionary fiscal policy? Government transfers will increase and taxes will decrease:

    Disposable Income ($50,000) == Personal Income ($50,000) + Government Transfers ($5,000) - Taxes ($5,000)

    With this change, you now have an extra $10,000 in disposable income! This can go to buying products that will help you during a recession. Imagine that everyone in the country receives the same benefit like you. You can probably see how everyone will be spending more on consumer goods, increasing the overall aggregate demand in the short run.

    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.

    Fiscal Policy Actions in the Short Run Contractionary Fiscal Policy StudySmarter OriginalsFig 2. - Contractionary Fiscal Policy

    Contractionary Fiscal Policy occurs when the government decreases spending and/or increases taxes to decrease aggregate demand.

    We can view the same example with the disposable income formula:

    Disposable Income ($63,000)==Personal Income ($60,000) + Government Transfers ($5,000) - Taxes($2,000)

    Your disposable income in this instance is $63,000. But what if the government implements a contractionary fiscal policy? Government transfers will decrease and taxes will increase:

    Disposable Income ($55,000)==Personal Income ($60,000) + Government Transfers ($0) - Taxes($5,000)

    With this change, you now have less disposable income than before the fiscal policy: $55,000. Having less disposable income will make you more hesitant to purchase goods and services in the short run, which is what the government wants! Currently, the economy is "overheating" and the government needs to decrease aggregate demand. Contractionary fiscal policy achieves this goal.

    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: Spending multiplier = 11-MPC

    Let's take a look at a brief example:

    What will the spending multiplier be if the marginal propensity to consume is .5?

    Spending Multiplier:11-MPC

    Plug in .5 for MPC

    Spending Multiplier:1.5=2

    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.

    Spending Multiplier helps calculate the total rise in real GDP caused by each $1 rise in aggregate spending.

    Visit our article - Expenditure Multiplier to explore more on this topic!

    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:

    Tax multiplier = -MPCMPS

    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:

    GDP=Change in Taxes ×Tax Multiplier (-MPC/MPS) Suppose the government wants to increase output by $20 billion, MPC is .6, and MPS is .4:$20 Billion=Change in Taxes ×-1.5Divide by -1.5 on both sides.-$13.3 Billion=Change in Taxes Therefore, we need to decrease taxes by $13.3 billion to increase output by $20 billion.

    As we can see, governments need to be careful about the amount they decide to alter spending and taxes. It will not always be a one-to-one increase or decrease in spending or taxes. Multipliers play a large role in determining the amount needed to stimulate or depress an economy in the short run.

    Marginal Propensity to Consume (MPC): The amount a household will spend from each additional $1 added to their income.

    Marginal Propensity to Save (MPC): The amount a household will save from each additional $1 added to their income.

    Visit our article - Tax Multiplier to explore more on this topic!

    Disadvantages of Fiscal Policy Actions in the Short Run

    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.

    1970's oil crisis

    The United States chose to increase aggregate demand (expansionary fiscal policy) in response to the 1970s oil supply shock. While this controlled unemployment, it increased inflation by a large amount. This was not an easy policy decision to make since any decision made would yield unwanted results.

    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.

    Fiscal Policy Actions in the Short Run - Key takeaways

    • Disposable Income is the income left over after taxes and government transfers.
    • Expansionary Fiscal Policy increases aggregate demand by increasing disposable income and encouraging consumer spending/investment.
    • Contractionary Fiscal Policy decreases aggregate demand by decreasing disposable income and discouraging consumer spending/investment.
    • The spending multiplier is used by governments to find how much government spending should be altered to reach the desired level of GDP (output).
    • The tax multiplier is used by governments to find out how much taxes should be altered to reach the desired level of GDP (output).

    References

    1. Sonja Pippin, Richard Mason, and Charles Carslaw, Tax Rebate Checks as Economic Stimulus, 2008
    2. Daniel J. Wilson, Fiscal Spending Jobs Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act, 2011
    3. Larry Berman, Coming to Grips with Lyndon Johnson’s War, 1993, http://www.jstor.org/stable/24912226
    4. Donald F. Kettl, The Economic Education of Lyndon Johnson: Guns, Butter, and Taxes, 1987
    Frequently Asked Questions about Fiscal Policy Actions in the Short Run

    What are the fiscal policy actions in the short run?

    The fiscal policy actions in the short run are Expansionary and Contractionary Fiscal Policies.

    How do fiscal policy actions affect inflation?

    Fiscal policy actions affect inflation in two ways: contractionary fiscal policy lowers inflation; expansionary fiscal policy increases inflation.

    What are the effects of fiscal policy actions in the short run?

    The effects of fiscal policy actions in the short run are to increase/decrease aggregate demand to reach equilibrium.

    When are expansionary fiscal policy actions used in the short run?

    Expansionary fiscal policy actions are used in the short run when an economy is in a recessionary period.

    What are some examples of fiscal policy actions in the short run?

    Some examples of fiscal policy actions in the short run are: increasing or decreasing government expenditure, increasing or decreasing taxation.

    Test your knowledge with multiple choice flashcards

    Which of the following occurs with a supply shock?

    Increasing disposable income will cause which of the following?

    Which of the following shows the downsides to fiscal policy action?

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