Fiscal Policy - Government Spending and Taxes

I'm Malaya. In the early stages of the COVID crisis,
governments around the world took quick action to support their economies.
As lockdowns shot at businesses. Governments quickly introduced emergency packages,
They increased spending on health care, and gave money to
people working in industries most hit by the lockdowns.
The US passed several bills that collectively pumped two point
eight trillion dollars into the economy to help support struggling
businesses and families in the first half of twenty twenty.
But as Joe Biden geared up to assume the US presidency,
he was still facing a weak recovery and chose to
pump another one point nine trillion into the economy after
he assumed office.
A lot of politicians were worried that if they didn't
do enough, the recovery could take years, much as it
did following the global financial crisis in two thousand and eight.
I think that worry was on everyone's minds. Governments often
step into counter booms and bus in an effort to
keep the economy on track, and you want to do
the right amount.
Fiscal policy is the term used to describe the government's
use of spending and tax policies to influence economic conditions.
And fiscal policy is our topic on this week's Think
Like an Economist with Me Betsy Stevenson.
And I'm just a Morphers. We're teaching you some powerful
tools from economics that you can use to transform your
life in the economy. NaSTA Antabercoli Fire is with us.
Last episode, we looked at monetary policy and how central
banks set interest rates. Now we're going to discuss how
policy makers can adjust government spending and tax policies to
help tame business cycles.
This is known as fiscal policy. When the government changes
its spending or tax policy. Government use expansionary fiscal policy,
which is spending more or cutting taxes when the economy
is weak and they're hoping to stimulate demand for more output.
They engage in contractioninary fiscal policy, cutting government spending and
or raising taxes. When the economy is starting to overeat
and they want to reduce demand.
In a recession, the problem businesses face is that there's
just not enough demant. People don't want to buy stuff,
so businesses have to cut back. They produce less, and
they create fewer jobs.
During the COVID pandemic, people stop buying a lot of
things like movie tickets, hotel stays, restaurant meals, gym memberships.
But also people just cut back across the board because
they weren't sure if they might lose their job later on.
So people get a little conservative in their spending.
And the people who worked in each of these industries,
they lost their jobs. They couldn't pay rent, they couldn't
buy basics like food. So those painful cuts spurred the
economy to an even deeper recession as they cut back more.
That led to more layoffs, which led to more cutbacks,
and so on.
The COVID recession provides a really unique lens for considering
what can happen. GDP fell sharply in March and April
of twenty twenty. Much of that was driven by plummeting
consumer spending with a.
Big COVID relief package past the US Congress in March
twenty twenty.
Right, Yeah, In fact, there were three bills that passed,
and they put a lot of money in people's hands.
And while people didn't start going to the movies or
hotels and restaurants because of COVID, it did stop and
reverse some of that snowball effect, and consumer spending really
picked up. In fact, consumer spending rebounded in May, even
though the pandemic was still accelerating. The worst of the
pandemic hadn't ended, but the worst of the recession had
ended because of that increase in government spending.
So the government gives people money and they spend it,
and that's expansionary fiscal policy.
That's one way to do it. Both the Trump and
the Biden administration sent out chicks to nearly every American
in the wake of the COVID recession. Tens of millions
of people also received payments through unemployment benefits.
These are called transfer payments because they transfer money from
the government's account to your bank account. Because these transfers
don't involve any production, they aren't directly counted as an
increase in GDP, but they can boost demand and output
and employment by incentivizing the people who get those payments
to spend more.
Likewise, a tax cut puts more money in people's hands,
and if you've got more money in your hands, you're
more likely to spend more.
And what about when the government makes purchases directly.
That also stimulates demand I mean, if there are a
bunch of unemployed people and underutilized equipment, it's a great
time for the government to build things like bridges and roads,
or fund research projects or update their computer equipment. When
the government purchases things or contracts or services, then it's
competing with the private sector, who might also like to
try to hire those workers or that company or buy
that product. With less demand from the private sector, it's
a good time for the government to get its projects done.
And realize when the government spends money, there are also
second and third round effis, when the government pays Bitsy's
construction company to build more roads, she'll need to hire
more workers. Those newly employed workers, they might buy more
sandwiches at your del emails.
And if I hire more people to make those sandwiches,
they'll then use some of their new income to buy clothes.
So the clothing store owner now has more money which
she might spend on something else, and so it goes on.
As an initial dollar of spending will have broader ripple effects.
So what Jetson's describing is the multiplier effect. This is
the idea that an extra dollar of government spending can
cause output to rise by more than a dollar. The
multiplier effect exists because of the interdependence principle that initial
dollar of spending boosts someone else's income, which can cause
yet more spending, which in turn will boo someone else's income,
which will cause more spending, and so on and so on.
The multiplier effect is really important when the economy is
in a slump, because then there's plenty of scope for
businesses to expand their output if only they could get
more customers.
The key to the multiplier effect is people spending that
money that the government's putting in their hands. So if
the government sends a stimulus check to you, Naz, and
you decide to pay off your credit card debt, then
that government spending it didn't boost output at all.
Yeah, and that's because paying off debt is the same
as saving. It boosts my financial situation, but it has
no impact on current GDP and doesn't generate income for anyone.
Right, Fiscal policy is most effective when it's targeted, timely,
and temporary.
Alliteration makes everything better, and these are the three t's
of fiscal policy. Targeted, Timely and temporary.
And targeted is about how it doesn't help to give
money to people who are going to save it, so
transfers to be targeted to those who are most likely
to spend it right, and.
The people most likely to spend it are often those
who need it most. Like if you've lost your job
and you get a checked in the government, you'll probably
use it to pay for food and housing, rather than
paying down debt or building up your saving or your
stock portfolio.
This is an important difference with monetary policy, which just
can't target specific groups.
Timely means that we want fiscal policy makers to act
quickly when they see the economy doing poorly.
That's the idea. Unfortunately, it doesn't always work out. Politicians
can be slow to respond, and even when an individual
politician wants to respond quickly, they end up bickering with
their party or with the other party, and it takes
ages to get to agreement. And then the government has
to find something to spend the money on, and if
they don't have shovel ready projects, there's nothing to spend
the money on, so the money doesn't get out the
door quickly enough.
Timely is also related to the last T, which is temporary.
This is the idea that there's no more need for
extra spending once the economy has recovered, so we want
those boosts to spending and expansionary monetary policy to be temporary.
In fact, if the economy is fully recovered and even
starts to operate beyond its potential, the government might want
to enact contractionary fiscal policy. We're not lower as government
spending and transfer payments and raises taxes.
These measures lead to less output. The government tends to
consider contractionary fiscal policy when it's worried that excess output
could lead to higher inflation.
So the government can switch between contractionary and expansionary fiscal
policy in an effort to count the ups and downs
of the business cycle.
So increased government spending is helpful when output is below potential,
but can be harmful when output is above potential, and
that's why fiscal policy should be timely and temporary.
That's right. Government spending can crowd out production by regular businesses.
This is because when the economy gets to full employment,
so resources start to be limited, the government ends up
competing with private sector businesses for those resources. For instance,
if the government hires folks, there are fewer workers left
for businesses to hire. If it borrows money, there's less
leftover for businesses to borrow, and that'll force up the
interest rate, which will force regular businesses to invest less.
That's another reason that own cyclical government spending is a
good idea. The government should expand its spending during recessions
and then contract it as the economy improves, because the
best time to make investments is when there are a
lot of idle resources that can be used.
Now, think about it. When does it make most sense
to start a big road building project when the economy
is in a recession and there are millions of unemployed
workers and lots of spare machines just sitting around unused,
or during a boom when everyone has a job and
inputs are hard to get hold of.
I see, So the government ought to invest in infrastructure
during an economic slump because that's when the opportunity cost
of these resources is really low.
Exactly, so, we have two rationales for the government to
spend more on a slump. The first is that it's
spending can help push the economy into a better place.
The second is that the recession is also when it's
cheapest to make much needed investments.
The last point about crowding out cautions against extra government
spending or cutting taxes when the economy has recovered and
is operating of its potential.
Some of this happens automatically because as the economy improves,
people earn more, so they pay more in taxes. They
also apply for fewer benefits from safety net programs.
These are called automatic stabilizers because they work to stabilize
things without policymakers having to do anything.
That's right. Automatic stabilizes a spending and tax programs that
adjust automatically is the economy expands and contracts, without the
need for Congress or Parliament to take any deliberate action.
In a recession, people lose their jobs and apply for
unemployment benefits at high rates. But as the economy starts
to improve, there are fewer people that are going to
draw on unemployment benefits. So government spending on benefits rises
automatically in the recession, but follows automatically as the economy
starts to improve. The government doesn't need to pass any
new laws.
So there's an imbold automatic tendency for government spending to
rise in a recession and to fall in an expansion.
Yeah, and the tax system does something pretty similar because
taxes are a percentage of your income. So if your
income files, your tax bill is going to fall.
There's also another more subtle reason why tax payments fall
during a recession when income's lower. When we have a
progressive tax system, then a lower income qualifies you for
a lower tax rate. And so as your income falls,
you're going to fall into a lower tax bracket, which
means that your tax payments will fall even more.
Overall, the government ends up with less tax revenue during a.
Recession, yes, and that means that people and business owners
get to keep more of their money, which hopefully they're
then going to spend.
What's great about automatic stabilizers said, they're also timely, targeted
and temporary.
They're timely because automatic stabilizers kick in whenever your income changes.
And they're targeted because, well, automatic stabilizers are going to
focus on the people who've had the biggest impact from
a recession or the biggest improvement from a boom.
And they're temporary because they automatically switch on or off
if the direction of the business cycle changes. Too.
We have two ways to deal with booms and busts.
We have monetary policy, and we also have fiscal policy now,
which is most effective and when.
Well, monetary policy is more nimble. Central banks like the
FAT are always assessing in the state of the economy,
and they can implement changes in the interest rate literally
by simply scheduling a meeting with the relevant policy makers.
But monetary policies also list erect Changes in the interest
rate can occur straight away, but those changes don't immediately
boost spending. Rather they change the incentives suspended. It may
take people a while to adjust, and so monetary policy
only affects the economy with what economists call long and
variable lags, and it can take a year or two
for the full effect to add up.
That's why I like the idea of a lot of
fiscal policy operating through automatic stabilizers because they operate quickly
and directly.
But an advantage of politicians jumping in with specific fiscal
policies is that they can be targeted. A change in
the interest rate will impact everyone in the economy, but
say a particularly industry or region is having trouble, Say
is the service sector was during the COVID recession, Well,
fiscal policy can be targeted to particular people in that
industry or in the affected regions, and we could make
even more automatic stabilizers respond in a more targeted way
like her unemployment insurance idea.
Fiscal policies especially important when interest rates are already low,
an idea known as the zero lower.
Bound, meaning that nominal interest rates can't be set to
below zero.
That's right, and so central banks sometimes fine, they can't
cut rates any further. When that happens, fiscal policy is essential.
We've been talking about some really big numbers and contents.
How can we think about fiscal policy as it relates
to our own lives.
Fiscal policy has a very direct impact on our lives.
During the COVID recession, many families around the world received
a check from the government, and for many of those families,
that check was the difference between going hungry and being
able to put some food on the table.
Fiscal policy during a recession puts money in the pockets
of lots of people, and that helps boost their spending,
which prevents other people from losing their jobs. This can
mean that unemployment doesn't rise as much as it otherwise would,
and that the economy recovers faster than it would without
fiscal policy.
So the direct effect is if we get physical policy
right economic conditions for all of us, they're going to
be a whole lot better.
Betsy justin thank you.
As there was a lot of fun chatting about fiscal
policy and how governments can help smooth business cycles. I
love this stuff, but I I have a feeling a
lot of our listeners are wondering about the elephant in
the room.
By elephant, he means a sixty one trillion dollar elephant.
That's the summ of government debt around the world. Government
debt is rising in a lot of countries and rose
substantially as countries.
Fark COVID government debt and deficits. What's going on and
whether we need to worry about them? They're our topic
on our next episode of Think Like an Economist.
Thanks for listening.
There's a lot more from this show and others like
it on the Himalaya Learning platform.
Himalaya Learning provides byite sized courses from world class thinkers
and industry experts for you to enjoy in the app
on the go.
For exclusive content, including bonus episodes and supplemental materials, go
to Himalaya dot com slash ekon and enter promo code
Ekon at checkout for your first fourteen days free.
Himalaya dot com slash econ has a load of great
shows like ours, so try it out. Using the promo
code ekon at checkout to get your first fourteen days free.
It's time to think like an economist.