Unit 5 Macroeconomic policy: Inflation and unemployment

5.6 Fiscal policy: How governments can dampen fluctuations

Unit 10 of the The Economy 2.0 Microeconomics discusses public goods and other market failures which provide a rationale for government intervention including through taxation and expenditures.

Governments collect money through taxes including on earnings, profits, consumption or value added, and specific goods like alcohol. They spend the revenue on a variety of goods and services as well as on transfers and the payment of interest on the government’s debt. Taxation and government spending are used to redistribute income, to provide social insurance and merit goods, and to address other market failures.

Fullscreen

https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-06-governments-and-fluctuations.html#figure-5-2

Figure 5.2

As Figure 5.2 showed, a larger size of government is correlated with less volatility in the economy. Here, we investigate the economic arguments for a causal link: how government spending and taxation can provide stabilization when the economy encounters shocks to aggregate demand. It can dampen fluctuations in three ways:

its direct impact on aggregate demand by virtue of its size and lower volatility compared with other components
the automatic stabilization of fluctuations that arises from the tax and transfer system, which indirectly affect consumption spending
the deliberate use of tax, transfer, and spending decisions (called discretionary policy) to offset shocks to aggregate demand.

Note that if a government has a high level of spending but limited capacity to collect taxes, then that combination can be a precursor to macroeconomic instability. This is discussed in Unit 7 (page 000). In Section 5.9, we also show how it can amplify shocks.

The government’s spending is large and less volatile than the private sector’s

Simply by virtue of its weight in aggregate demand, government spending can have a stabilizing impact compared to business investment or even consumption, which are more volatile. Spending on health and education, which are the two largest government budget items in most countries, does not fluctuate with business confidence or variations in growth in the rest of the world. An unintended consequence of a larger weight of these kinds of government spending—assuming that taxes are raised to fund them—is that it stabilizes the economy.

Automatic stabilizers

automatic stabilizers: Automatic stabilizers are tax and transfer policies that have the effect of offsetting an expansion or contraction of the economy. For example, spending on unemployment benefits rises during a recession.

A side effect of policies aimed at income redistribution and social insurance is to smooth fluctuations in economic activity. This happens because of the operation of automatic stabilizers.

During a boom, we expect people’s personal incomes and corporate profits to rise. As incomes rise, tax receipts will also increase automatically. This puts a damper on economic growth and, in this way, acts as an automatic stabilizer. Section 3.8 showed how a proportional tax system reduces the size of the multiplier and dampens the business cycle. There will be an additional dampening effect as higher incomes take people into higher tax brackets. If income tax brackets are not adjusted for inflation, a rise in inflation will also trigger a dampening effect on aggregate demand through the same mechanism.

Government-provided unemployment benefit systems are a particularly important example of an automatic stabilizer. In a recession, we expect unemployment to rise. This may be accompanied by an increase in the percentage of households that become eligible for income support programmes. As a result, government spending on transfers in the form of unemployment and other means-tested benefits rises. This increase in government outlays will occur automatically and the support enables households to maintain higher consumption than would be the case in their absence.

Although households save to smooth fluctuations in income, few households save enough (that is, self-insure) to fully cope with an extended period of unemployment. Many are credit constrained and cannot borrow, so unemployment benefits support consumption.

co-insurance: A co-insurance scheme enables households to pool savings so that individual households can maintain consumption when they experience a temporary fall in income or the need for greater expenditure.
moral hazard, hidden actions: If there is a conflict of interest between a principal and an agent over the agent taking some action that cannot be observed or cannot be verified by a court, then the principal faces a problem of hidden actions; also known as moral hazard.
asymmetric information, asymmetry of information: Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.

Could workers insure privately against job loss? There are three reasons why the private market fails, and therefore governments provide a limited level of unemployment insurance in the form of unemployment benefits:

Correlated risk of job loss: In a recession, job loss will be widespread. This means that there will be a surge in insurance claims across the economy and a private provider may be unable to pay out on the scale required. It also means co-insurance ⁠ among a group of neighbours or family members may be of limited use when the need for help arises in many households at the same time.
⁠Hidden actions: An insurance company cannot observe the reason for the job loss. So insuring the employee against a firm cutting back employment due to lack of demand would also apply to the worker being fired for inadequate work. This creates a moral hazard because a well-insured person may make less of an effort on the job.
Hidden attributes⁠: Suppose you learn that your firm is in difficulty, but the insurance company does not. If the insurance company offers good rates, you would buy insurance and be likely to make a claim on them.

adverse selection, hidden attributes: A hidden-attributes or adverse-selection problem occurs when some characteristic of a product or service being exchanged is not known to the other parties. For example, someone purchasing health insurance knows their own health status, but the insurance company does not. The lack of information affects the price at which the uninformed party is willing to buy or sell, and this can lead to an ‘adverse selection’ of goods in the market: for example, only the least healthy people wanting to buy health insurance.

The hidden actions and hidden attributes problems are examples of asymmetric information. In both cases, those with good prospects will shun the insurance and the insurer will be left with those likely to face the extra risks of losing their job. This is called adverse selection. As a result, providing private insurance against job loss is not a good business proposition. By contrast, the government is able to support incomes even in an economy-wide recession because it has the power to levy taxes, which will enable it to repay the debt that accompanies the income smoothing it supplies.

Discretionary fiscal policy using spending, transfers, or taxes

fiscal policy, discretionary fiscal policy: Fiscal policy refers to policies setting the levels of taxes, transfers, and goverment spending. Since fiscal policy affects the level of aggregate demand, it may be used by the government to stabilize the economy by changing aggregate demand; in this case, it may be described as discretionary fiscal policy. See also: aggregate demand.

The third way in which government spending and taxation can dampen fluctuations is when the government intervenes deliberately to stabilize aggregate demand using fiscal policy as in Section 5.3. This is called discretionary fiscal policy.

When a government cuts taxes or increases government spending in a recession, it is called a fiscal stimulus. An example is shown in Figure 5.5. The opposite is when the government reduces spending or raises taxes to control a boom, which is called a fiscal contraction.

Parliaments have power over budgetary decisions, and responsibility for other short- and long-term objectives of tax and spending in addition to stabilization. This is one reason why stabilization policy is often handled through monetary, rather than fiscal, policy. Nevertheless, fiscal policy can play an important role in stabilization, especially in particularly large downturns.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 in the United States is an example of a fiscal stimulus package. You can read more about it on the US Treasury website.

In response to the global financial crisis in 2007–2009 and the COVID-19 pandemic in 2020, governments acted very swiftly to stabilize aggregate demand using fiscal policy. During COVID-19, fiscal stabilization was almost entirely through transfers rather than through higher spending on goods and services. In Europe, furlough schemes were implemented in which governments paid a high proportion of the wages of workers who were unable to work because of government restrictions. In the US, higher unemployment benefits were paid during COVID-19.

Question 5.3 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

A proportional tax system provides an automatic stabilization effect on aggregate demand, especially if tax brackets are not adjusted for inflation.
Government spending on its ‘standard’ unemployment benefits programme (the parts that remain constant across the business cycle) is an example of discretionary fiscal policy.
If the risk of job loss was not correlated across individuals in an economy, then private insurance against job loss would be a feasible alternative to unemployment benefits.
Discretionary fiscal policy measures usually have a longer time lag between the need for a change in aggregate demand and implementation than is the case with monetary policy measures.

When incomes rise, workers may move into higher tax brackets and pay more income tax. If tax brackets are not adjusted for inflation then this effect is stronger.
Discretionary fiscal policy refers to changes in government spending and taxation in response to the business cycle.
Even if the risk of job loss was not correlated, private insurance markets are likely to fail because of moral hazard (hidden action) and asymmetric information (hidden attributes).
Discretionary fiscal policy measures typically require approval by the government, which can take longer to enact than changes in the interest rate, so stabilization policy over the business cycle is often handled through monetary rather than fiscal policy.

Exercise 5.4 Contributions to change in real gross domestic product over the business cycle

The table below shows the contributions that the main components of expenditure (C, I, G, and X − M) made to US GDP growth during the recession of 2009.

	GDP	Consumption (C)	Investment (I)	Government spending (G)	Net exports (X − M)
2009	−2.8	−1.06	−3.52	0.64	1.14

We can use FRED to analyse whether these contributions changed during the recovery phase of the recession.

Go to the FRED website. You can watch this short tutorial to understand how FRED works. Search for ‘Contribution to GDP’ using the search bar, and select this annual series:

Contributions to percentage change in real gross domestic product: Personal consumption expenditures

Make sure the frequency is quarterly. To change the frequency of your series, click the ‘Edit graph’ button above the top-right corner of the graph.

This button also allows you to add other series to your graph. Click on ‘Add line’ and search for the following series:

Contributions to percentage change in real gross domestic product: Gross private domestic investment
Contributions to percentage change in real gross domestic product: Government consumption expenditures and gross investment
Contributions to percentage change in real gross domestic product: Net exports of goods and services

Finally, add a series for real GDP (‘Real Gross Domestic Product’, setting the unit to ‘percentage change’). Make sure you select quarterly frequency for all series on your graph. Then answer the following questions for the period 2007 to 2014:

Do the contributions to GDP add up approximately to the growth of GDP?
Describe the contributions to US GDP growth in the recession (2008 Q1 to 2009 Q2) and in the recovery phase from 2009 Q3 of the business cycle. If you analyse the data using the FRED graph, the recession is shaded in the chart. Prepare a table like the one shown in this exercise.
What might explain the differences in the role of consumption and investment during the recession and recovery phases of the business cycle?
From the contribution to GDP growth of government consumption and investment expenditure, what can you infer about the US government’s fiscal policy during the crisis? What aspect of fiscal policy does this omit?

Note: To make sure you understand how these FRED graphs are created, you may want to extract the data into your spreadsheet and reproduce the series.