Discretionary Fiscal Policy to Recover the Economy from Recession - Essay Example

? Discretionary fiscal policy is one of the tools that the government can use in helping the economy recover from recession. In fact, discretionary fiscal policy is so important that some even suggest for it to have an automatic trigger, where it can combat circumstances that can make it ineffective, such as time lag. The purpose of this paper is to explain the advantages and disadvantages of having an automatic trigger for discretionary fiscal policy. Specifically, this paper seeks to look at how fiscal policy will affect the economy when there is an IS or MP shock. Perhaps, one of the benefits of having this new policy is that it can help the economy to maintain the level of output in the presence of an IS or MP shock without suffering from time lag. However, this policy has some disadvantages worth mentioning. For instance, it can cause a more volatile inflation. It can also create an opposite force in the economy when the Federal Reserve wants to do a monetary policy. Moreover, it can potentially widen the national’s budget deficit. Hence, the proposal on having an automatic trigger for discretionary fiscal policy may not be necessary, since the cons outweigh the pros. To have a better understanding on how an automatic trigger of discretionary fiscal policy can affect the economy, some changes in the basic IS-MP model must be made. At present, since there is going to be an automatic increase in government purchase and decrease in taxes whenever output decreases, government purchase, denoted as G, will be made into a negative function of output and taxes, denoted as T, which is a positive function of output. Hence, if there is a decrease in output that is caused by any shock, then government purchase will increase and the tax will decrease immediately. Thus, this modification can be incorporated into the Keynesian cross diagram. Now, the expenditure function will be: E = C(Y-T(Y))+G(Y)+I(r) This change will affect the shape of the expenditure curve in the Keynesian cross diagram. The expenditure curve becomes flatter as output becomes less responsive. By virtue of this new expenditure function, the new IS curve can also be derived by simply looking at the relationship between the level output and the real interest rate. As a result, the new IS curve will be: IS = C(Y-T(Y))+G(Y)+I(r) Following this equation, the IS curve will be steeper because now, the change in output is less responsive. This change in the IS curve will affect how the economy will behave in the presence of an exogenous shock. By having this new modification for the basic IS-MP model, the AD-IA diagram can also be derived, where the new AD curve is steeper compared to the initial one [Figure 1]. Figure 1. Keynesian Cross, IS-MP, and AD-IA Diagrams with an Automatic Trigger for Fiscal Stimulus. By having the newly modified IS curve, output is going to be more stable if there is an IS or MP shock. This can be demonstrated clearly with some examples. For instance, in Figure 2, it can be assumed that the economy is at the potential output and there is a negative IS shock, such as a decrease in consumer confidence. As a result, IS curve will shift leftward and output will fall, forming a negative output gap in the economy. However, since the new IS curve is steeper, the decrease in output is not as large as when there is no automatic trigger for discretionary fiscal stimulus because now, government purchase will increase and tax will decrease as well. Another example is that if the economy is facing a supply shock that shift MP curve leftward, there will be a less decrease in output as compared to when the economy is not having an automatic trigger for discretionary fiscal stimulus. Thus, having an automatic trigger of discretionary fiscal policy is beneficial in maintaining the output level if there is a negative IS and MP shock. Figure 2. The Immediate Effects of a Negative IS shock with an Automatic Trigger for Fiscal Stimulus. One disadvantage of having an automatic trigger for discretionary fiscal stimulus is that when the central bank wants to implement a monetary policy, there will be an opposite force in the economy because of the automatic trigger for fiscal stimulus. As an effect, if the central bank targets a specific level of output, it needs to adjust the real interest rate by a significantly higher amount, which will make the real interest rate become more volatile. The IS-MP diagram can help to illustrate this point more clearly. Looking at Figure 4, we initially have a negative output gap in the economy. If the central bank wants to do an expansionary monetary policy in order to bring back the economy to the potential output, then it needs to significantly lower the real interest rate compared to the time when the economy does not have an automatic trigger for discretionary fiscal stimulus. As a result, a large change in the real interest rate will only have a smaller effect on the economy. This phenomenon happens because the monetary policy and the fiscal policy are working in the opposite direction. While the central bank wants to stimulate the economy by lowering the real interest rates to increase output, the fiscal stimulus influences the economy by cutting government spending and raising taxes, which will decrease output. Thus, with these two policies working in opposite directions, it will be difficult for the economy to reach a potential level. Figure 4. The Effects of Expansionary Monetary Policy in Newly Modified IS-MP Diagram Another disadvantage of having an automatic trigger for discretionary fiscal stimulus is that it will cause more volatility of inflation. To elaborate this point further, we can compare the AD curve with an automatic trigger for fiscal stimulus and the basic AD curve in the AD-IA diagram. Suppose that the economy is facing a positive IS shock, such as an increase in consumer confidence. This will cause the AD curve to shift to the right, creating a positive output gap in the economy. In the long run, the steeper AD curve, which is the one with automatic trigger for discretionary fiscal stimulus, the higher the level of inflation will become, as the IA curve adjusts, compared to the original AD curve. Thus, in this particular example, automatic trigger for discretionary fiscal policy will cause an inflationary problem that is harmful for the economy. The Burns era during the 1970s in the US provides a clear evidence on how bad inflation can affect the economy. At that time, the government and central bank were doing expansionary fiscal and monetary policies to combat the high unemployment rate. As a result, the unemployment rate went down, but in reality, inflation was rising. On 1974, the inflation rate in the US was two digits in comparison to the current inflation rate, which is 2%. This condition of high inflation rate is believed to harm the economic growth in the long run because of the lack of price stability and increase in public uncertainty (Romer and Romer, 2004). Figure 5. The Long Run Effects of an Automatic Trigger for Fiscal Stimulus in AD-IA diagram Furthermore, automatic trigger for discretionary fiscal stimulus can widen the budget deficit of the US government. In fact, since 2002, the US government has running a growing budget deficit. Shown in Figure 5 is the actual and projected US government debt by the Congressional Budget Office. This projection was created by assuming that there is no change in government’s spending and policy. According to this figure, in the next 30 years, government will have an increasing debt each year, which in total would create a larger debt, compared to post World War II (Economic Report of The President, 2010). Thus, with the automatic trigger for fiscal stimulus, where the government purchase and taxes are both functions of output, the government loses its full power to control the budget. Anytime the economy has a decreasing output, the government purchase will increase and taxes will decrease. This scenario will create a larger government spending and smaller revenues, which will further increase budget deficit. In the event that this will happen, the US government will be forced to push for a higher real interest rate so that they can finance their debt. However, one problem that might appear because of this is crowding out in the economy. As the real interest rate increases, the cost of borrowing will also increase. Thus, private investors will decrease their willingness to lend money, potentially decreasing the investment. Decrease in investment will result in decrease output in the long run (Elmendorf and Fulman, 2008). With this, we can see that although the automatic trigger for fiscal stimulus might help the economy to recover in the short term period, it causes a bigger problem for output in the long run. After evaluating the advantages and disadvantages of having an automatic trigger for discretionary fiscal stimulus, the author does not recommend this policy because the cons outweigh the pros. Although it can combat the ineffectiveness of fiscal stimulus by maintaining output level immediately after an IS or MP shock, it causes problems that are more critical, such as an incontrollable opposite force between fiscal and monetary policy, a high volatility of inflation, and increase in government’s debt. These problems occur because fiscal stimulus enters the economy without government’s control. According to the analysis presented in this paper, the best possible solution is for the government to launch fiscal policy like the usual, but the process should be made faster so as to minimize the ineffectiveness of fiscal policy. Read More