In chapter 16 we learned about fiscal policy –the federal government’s tool kit

Question

In chapter 16 we learned about fiscal policy –the federal government’s tool kit for addressing business cycle fluctuations. In chapter 12 we learned that business cycle fluctuations are caused by changes in aggregate expenditure. One implication of this idea is that if we are in a recession, it is because total spending has decreased. Therefore, if we want to get out of a recession, total spending needs to increase. Chapter 16 offers two ways to stimulate total spending –through tax cuts or increases in government spending.

Typically, Republicans favor tax cuts, while democrats favor increases in government spending. There are economic rationales for both positions. Tax cuts put money into the pockets of consumers, who are better than the government at determining how resources should be allocated –this promotes “allocative efficiency” (from chapter 1). On the other hand, the tax multiplier is smaller than the government purchases multiplier (see section 16.4 in the text). This means that we get more economic stimulus from a given dollar value of government spending than the same dollar value in tax cuts.

The tradeoff here is between more efficiency (with tax cuts) vs. more economic stimulus (with government spending). Differences of opinion on this matter are cause for heated political debate and overblown political rhetoric.

So what do you think? Do you prefer economic stimulus from tax cuts or increases in government expenditure?

Explanation / Answer

Looking the problem from an economists point of view, a mixture of both the policies is a bettrer way out to deal with the economic downturn and obviously, a mixture of two will gain tha quick momentum and bring the economic out of recesssion than just sticking to one policy.

Mainly by increasing the spending the economy can revive. Although using both the policy options together may burden the government under huge debt, but this is a cyclical debt which will be paid off as soon as the economy recovers and moves towards potential output level. It is at times that simply by cutting taxes, people prefer leisure over work, which would disincentivise agrregate spending/demand. On the other hand, just by increasing the spending, disposable income would be less again aggregate demand not increasing to full extent. So a mixture of two would work better.

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