Case Assignment: Fiscal Policy

Case Assignment

Submit a 5-page paper that addresses the following questions. Be sure to use references within the paper to support your answers. Show work for all calculations.

1. Which has a larger effect on aggregate demand: an increase in government expenditure or an equal-sized decrease in taxes? Explain your answer.
2. To eliminate a recessionary gap, which fiscal policy should the government pursue? Be specific.
3. The online text discusses fiscal policy in action. Keynesian economics is a school of thought that believes fiscal policy is needed to stabilize the fluctuations in the real GDP. Classical economists such as Adam Smith believe that the economy is most efficient without government intervention. Suppose you are an advisor to a presidential candidate. Which school of thought would shape your economic plan and why? Be sure to use references to support your answer.
4. The majority of lobbying efforts center on fiscal policy. Please discuss your opinions on lobbying regarding whether it is useful and should continue as is, it should continue but with constraints to limit how much is done, or it should be eliminated.

Assignment Expectations

Use information from the modular background readings as well as any good quality resource you can find. Make sure you cite all resources you use and provide a reference list at the end of your paper.

Length: 5 typed and double-spaced pages.

In addition to the overall quality, depth, grammar, and organization of the paper, the following will, in particular, be assessed:

1. The level of your understanding of the key concepts of the major macroeconomic indicators.
2. Some in-text references to modular background readings (APA formatting encouraged).

Upload your assignment to the Case 2 dropbox when completed.

• Government Expenditure vs. Tax Cuts

Slowdown or economic recession translates to issues such as high unemployment which, in turn, weakens the overall aggregate demand. In such scenarios, it is up to the government to administer fiscal policy tools such as government spending and tax cuts to help strengthen the aggregate demand. Government spending entails the purchase of goods and services by the government with the aim of influencing economic output (Goodwin, Nelson, Harris, Torras, & Roach, 2013). The fiscal policy can either lower or raise the GDP depending on whether the government has increased or reduced its spending.

When the government increases spending, it adds to aggregate demand and also boosts economic equilibrium. Similarly, a decrease in spending lowers the aggregate demand. As a fiscal policy, taxes influence the incomes of consumers in the economy thereby leading to changes in consumption and real GDP ultimately. When the economy is in a slowdown, the government can reduce taxes thereby enhancing consumers’ purchase power which, in turn, adds to the aggregate demand (Goodwin et al., 2013). Economists have always argued on which tax and spending policies are best for distinct economic situations. Both policies effect change in the economy differently, and hence, they have different impacts on aggregate demand.

Generally, an increase in government expenditure has a larger effect on aggregate demand than an equal sized decrease in taxes. This is due to various reasons, one of them being the mechanisms by which the policies affect change on the economy. While tax cuts have an indirect effect on aggregate demand, the effect of government spending is direct (Goodwin et al., 2013). The impact of spending is direct in that when the government buys services or goods, it adds to aggregate demand immediately. As for tax cuts, they affect consumer income thereby indirectly affecting consumption and aggregate demand. Additionally, even if a consumer receives a tax cut say of 40, it is not certain that they will spend the whole 40 and add it to aggregate demand. The consumer can choose to use some portion of the cut to reduce debt or increase saving. Evidently, tax cuts affect aggregate demand and consumption indirectly by directly influencing consumers’ disposable income. As such, their effect on economic equilibrium and aggregate demand is less than that of government spending which affects aggregate demand directly.

• Fiscal Policy for Recessionary Gap Elimination

A recessionary gap shows the difference between real GDP and potential GDP (Iyer, 2015). This potential GDP is that which would be experienced if the economy was operating a full-employment level. However, an economy does not always operate at the full-employment. Operation below the full-employment level translates to a difference between the potential full employment equilibrium and the actual ones hence leading to a recessionary gap. This gap usually pushes prices down in the long run. It is caused by factors such as government expenditure, tax changes, price fluctuations, and an excess population (Iyer, 2015). In most cases, a recessionary gap is experienced when an economy is approaching recession. It has effects such as lower production, increased unemployment, lower economic growth, and contraction of the business cycle. As such, it is imperative for the government to intervene and administer solutions which will eliminate the gap. The solutions can entail allowing the recessionary gap to return to equilibrium at its own pace or using fiscal policy to eliminate it.

The best fiscal policy for the elimination of a recessionary gap is an expansionary one. Such policy is typically what governments use when an economy is hit by a recession. It seeks to enhance economic growth by increasing the supply of money in the market (Iyer, 2015). Specifically, the expansionary policy would entail using reduced taxation and increased government spending to increase aggregate demand. By increasing spending, the government can directly increase the aggregate demand which is lower than it would be in a full-employment situation. The spending should be specifically targeted to building infrastructure projects which can create employment. Increased spending will most likely have a positive impact on peoples’ income and also benefit most industries thereby creating a multiplier effect on the economy. For instance, if the government increases spending by starting a road project, they will have created employment for the people who will work on it. The increased income will lead to increased consumer spending which will, in turn, benefit the local shops and bars. Ultimately, there will be an increase in GDP and reduction in the recessionary gap. The government can also choose to cut taxes thereby indirectly affecting the aggregate demand curve. When the government cuts taxes, consumers will have a higher disposable income and will be more likely to spend and hence add to the aggregate demand and real GDP ultimately. Generally, the tax reduction and increased spending actions in an expansionary policy will translate to a shift of the aggregate demand curve to the right which will, in turn, contribute to the elimination of the recessionary gap. 

• Keynesian vs. Classical Economics

Classical and Keynesian economics are the two major schools of thought in economics. Since time immemorial, economists who believe in either school have been at loggerheads regarding the various ways through which an economy affects people and vice versa. Classical economists believe that a free and self-regulating market can lead to an efficient outcome (Patil, 2011). They hold that economies are most efficient without government intervention. The classical economic theory has its basis on the fact that free markets can regulate themselves if left free of any human intervention. As for the Keynesian economic theory, it is based on the fact that there is no divine entity that can tide a country over economic difficulties, and hence, people intervention is necessary (Patil, 2011). Keynesian economists believe that government intervention is a prerequisite for economic growth and stability. According to the theory, markets are flawed, unstable, and full of disturbances caused by factors such as lack of information, and hence, government interventions are needed to correct the market oscillations and keep it as smooth as possible.

If I were to advise a presidential candidate, the Keynesian school of thought would shape my economic play. Even though some markets have proved to be self-correcting, there are times when they fail to correct, and this can translate into disastrous effects. For instance, waiting for insufficient demand to correct itself can fail and lead to persistent or high unemployment. In 2008 and 2009, the country suffered the worst recession since the great depression (Sightings, 2012). The country also experienced a weak recovery and is even yet to recover fully. With such recession threats and effects, the best way to handle the economy at the moment is through a Keynesian approach. In China, the approach has helped them avoid a recession from 2008 through 2016. The approach helped the country maintain growth throughout in a period which was basically a recession for most of the world. China consistently continued to utilize fiscal spending to stimulate their economy and avert all ill effects which were being experienced in the rest of the world (Menla & Dimitraki, 2014). Currently, what the U.S needs is an increased spending by the government on infrastructure, more price stickiness (no lowering wages), and fewer trade deficits (Sightings, 2012). All these factors are proponents of the Keynesian approach. The approach would pave the way for an expansionary fiscal policy and would help in creating more employment and increasing the current aggregate demand and real GDP.  

• Lobbying and Fiscal Policy

Lobbying can be described as an advocacy by individuals or groups that is aimed at influencing decisions made by the government (Weiser, 2015). Lobbyists are usually professionals who are hired by special interest groups to represent their interests in Congress. Most of the lobbying efforts are usually centered on fiscal policy. The lobbyists try and influence decisions by the government regarding economic policies. For instance, there are currently various groups which are lobbying against Trump’s proposed policy to introduce tax cuts. Lobbying is completely legal in the U.S and is protected under the First Amendment (Weiser, 2015). It is seen as an important lever for a productive government that helps in sorting out of the many competing interests of citizens.

While lobbying is legal and an integral part of any modern participatory government, it can also lead to inefficient economic policy. Particularly, lobbying can dampen economic growth through rent-seeking. This is a process where one seeks income through special favors from the government rather than through productive economic activity (Craig & Madland, 2014). The behavior has multiple negative effects on the economic well-being. People tend to spend their time trying to get a larger piece of the economic pie, and usually, the policies they seek are inefficient, wasteful, or even harmful. A study conducted to assess the influence of lobbying indicated that it reduces a company’s effective tax rate. A 1% increase in lobbying expenditure can translate to a tax reduction of approximately 0.5 – 1.6% (Craig & Madland, 2014).  

Since lobbying has a negative effect on the economy through a process such as rent-seeking, it would be important to regulate the activity. Limits should be imposed on lobbying for the purposes of promoting productive economic activity.

References

Craig, J., & Madland, D. (2014, May 2). How campaign contributions and lobbying can lead to inefficient economic policy. Center for American Progress. Retrieved from https://www.americanprogress.org/issues/economy/reports/2014/05/02/88917/how-campaign-contributions-and-lobbying-can-lead-to-inefficient-economic-policy/

Goodwin, N., Nelson, J., Harris, J., Torras, M., & Roach, B. (2013). Macroeconomics in context. ME Sharpe.

Iyer, S. (2015, May 7). Recessionary gap: Causes, effects, and potential solutions. Retrieved from https://www.buzzle.com/articles/recessionary-gap-causes-effects-and-potential-solutions.html

Menla Ali, F., & Dimitraki, O. (2014). Military spending and economic growth in China: A regime-switching analysis. Applied Economics, 46(28), 3408-3420.

Patil, S. B. (2011). Classical Economics vs. Keynesian Economics. Buzzle Web Portal: Intelligent Life on the Web, http://www.buzzle.com/articles/classical-economics-vs-keynesianeconomics.

Sightings, T. (2012, July 17). How would Keynes save our economy? Retrieved from https://money.usnews.com/money/blogs/on-retirement/2012/07/17/how-would-keynes-save-our-economy

Weiser, D. (2015, April 30). Why lobbying is legal and important in the U.S. Retrieved from https://www.investopedia.com/articles/investing/043015/why-lobbying-legal-and-important-us.asp