SESSION 2: PROBLEMS OF FINE-TUNING AGGREGATE DEMAND
Welcome to the second session of unit three. In this session, we want to look at the problems associated with the use of fiscal policy as a demand management tool in an economy.
Objectives At the end of this session, readers should be able to
- explain fiscal policy and fine-tuning
- understand Fiscal policy and business cycles
- enumerate the problems associated with fine-tuning
Now read on…
Read Session 1: FISCAL POLICY AND GOVERNMENT FINANCE
2.1 Fiscal Policy and Fine-tuning
When there is a deflationary gap, the government could either increase government spending or decrease tax rates. Due to the multiplier effect, either of these measures would result in an increase in demand that is multiplied. Similarly, when there is an inflationary gap, the government could either reduce spending or increase taxation.
Again, these measures would reduce aggregate demand, this time via a negative multiplier effect. In this manner, fiscal policy is frequently described as a policy of fine-tuning aggregate expenditures to maintain national income equilibrium at full employment output without inflation.
2.2 Fiscal Policy and Business Cycles
Keynesians believe that governments can mitigate cyclical fluctuations in national income through the use of fiscal policy to fine-tune demand.
Keynesians believe that the government can use contractionary fiscal policy measures during economic booms and expansionary fiscal policy measures during economic busts to counteract short-term fluctuations in the level of economic activity, also known as business cycles.
These decisions are frequently referred to as counter-cyclical fiscal policy. If appropriate fiscal actions are taken at the appropriate time, always, then short-term fluctuations in economic activity should be neutralized, allowing the economy to develop smoothly along its long-term growth path.
Fiscal Policy and Business Cycles
The government’s use of fiscal policy measures to influence the level of economic activity is known as discretionary fiscal policy (or stabilization policy). In contrast, fiscal policy contributes to the automatic stabilization of economic activity.
For example, if unemployment rises, the government’s tax revenue will likely decrease. As unemployment rises, government spending on various forms of welfare benefits will inevitably increase.
The decline in tax revenue represents a decrease in leakage from the circular flow of income, whereas the increase in government expenditure represents a greater injection into the circular flow.
These effects result in a slower decline in aggregate demand than would occur in the absence of government involvement in the economy.
In this context, fiscal policy is referred to as an automatic stabilizer, meaning that the government has not taken any deliberate steps to counteract the decline in aggregate demand caused by increasing unemployment. The effect occurs automatically as a result of the shift in economic activity.
2.3 Fiscal Policy, Aggregate Demand, and Aggregate Supply
Let us now show the effects of using aggregate demand (AD) and aggregate supply (AS) curves to remove inflationary and deflationary gaps. Using the figure below.
Fiscal Policy, Aggregate Demand, and Aggregate Supply
In Figure (a), a reduction in tax rates or an increase in government spending causes the AD curve to migrate to the right, indicating an expansionary fiscal policy. This increases the real national income (GDP).
Similarly, in Figure (b), an increase in tax rates or a reduction in government expenditure results in a decline in aggregate demand and real national income, which represents a contractionary policy.
Both increases and decreases in aggregate demand result in a shift along the aggregate supply curve (AS), as well as an impact on the price level and real national income.
2.4 Problems with Fine-tuning Aggregate Demand
Uncertainty surrounds the extent to which the low unemployment rate was the result of Keynesian demand fine-tuning. Sometimes unemployment and inflation both increase, resulting in stagflation, which Keynesian economics appears unable to combat with fiscal measures alone.
Stagflation is a condition characterized by increased unemployment and inflation. To reverse rising unemployment, Keynesians advocate reducing taxes and increasing government spending to stimulate total demand in the economy, while addressing inflation requires higher taxes and reduced government spending to reduce aggregate demand. However, both policies cannot be pursued simultaneously.
The introduction of a prices and incomes policy was one potential remedy to this dilemma. The idea was that inflation could be contained by voluntary or mandatory limits on wage and price increases, while fiscal measures supported employment.
For instance, the government could concur that wages should be frozen or allowed to increase by no more than, say, 3% per year, in line with the increase in labor productivity in the economy.
2.5 Limitations of Discretionary Fiscal Policy
Fine-tuning aggregate demand through changes in government spending and taxation is likely to have limited success for a number of reasons discussed below;
- The full impact of government spending programmers may take a long time to feed through into aggregate demand, reducing the ability of governments to fine-tune economic activity successfully.
- Once state expenditure is increased it may be difficult to reverse the spending. It makes no sense to the electorate to leave bridges, roads, hospitals, etc. half-built, and once pensions and other welfare provisions are increased, it is not politically easy to attempt to reduce them.
- The cost of large-scale government projects has a tendency to escalate out of all proportion to original estimates once the projects have commenced.
- Taxation including social security contributions as a percentage of GDP tends to drift upwards as governments raise taxes to finance higher state spending more often than they reduce them.
- In general, government spending plans have become politically sensitive and therefore cannot be easily directed to fine-tune aggregate demand in the manner Keynesian economists recommend.
At various times in the past, the idea that the government, by altering its expenditures and taxation levels, can substantially influence aggregate demand and, consequently, the level of economic activity, has been appealing.
However, the onset of stagflation and the failure of prices and income policies demonstrated that fine-tuning is not the optimal course of action. This session examined the difficulties associated with adjusting the economy with discretionary fiscal policies.
Self-Assessment
Question Exercise 3.2
- Explain the limitations of discretionary policy
- Explain the following terms
- Stagflation
- Business Cycles
- Automatic Stabilizer
- Counter-Cyclical Fiscal Policy
- Incomes and Prices Policy
