Fiscal Policy Essay, Research Paper

Supposing the status quo of the United States today states that: there is no real unemployment, the consumer price index is rising at 2 percent annually, and the federal government budget deficit, 200 billion dollars, is equal to 5 percent of the gross national product. Now, the question is how and what changes will result from fiscal and monetary policy.

For example, if legislation has just passed which holds government spending constant and raises personal income taxes enough to balance the budget, then obviously the deficit would cease growing, as mentioned, along with other fluctuations of the gross national product as a whole. Because the government will stop borrowing money, it will also cut down on the spending, which will cause the economy to slow down as is illustrated by the equation: Y = C + I + G + X. In the short run people will respond to the raised taxes by decreasing their consumption, while simultaneously the marginal propensity to consume will increase because people will have less money to save. Therefore, the short run effects of this fiscal policy will force companies to lower wages, produce less, and/or lay off a portion of the work force.

All the while The Fed is working up their counter cyclical monetary policy to keep deviation from the potential GDP to a minimum. The Federal Reserve Bank goes public with its goal to significantly increase the money supply. Due to rational expectations of the consumer, people might begin to consume more, looking forward to a rise in prices in the near future. If the Fed happens to achieve its goal, then the interest rates will drop in the short-run because they have a tendency to be positively related to government expenditure. The surge in the money supply will not only up the multiplier, but will hopefully lead to a balanced budget multiplier. The Fed intends to do this by matching the change in government spending with an equivalent change in taxes. With more money circulating amongst the banks, and eventually the people, the dollar will soon depreciate in value or in other words: inflation. Furthermore, being that the interest rates are negatively related to the rising price line (inflation), consumption will increase, and so will investment, because there will be more incentive to borrow, and therefore buy houses, or advance in technology through resource and development, meaning a balance or increase in output and/or employment.. Moreover, the new exchange rate also encourages export, which will theoretically accomplish the government goal of managing a good economy while decreasing spending and paying off the deficit.

Since there is usually a six month period between the time legislation is passed, and the time that the results become visible, the government and the Fed should allow approximately a year to stabilize the economy. However, that’s only assuming that the central bank implements their policies at the correct time. To cite an example, suppose that the President announces to pay off the deficit with an immediate tax hike in January. Hypothetically speaking, all the results mentioned in the second paragraph will become apparent around June. Alan Greenspan will at this point alert the people of his intention to increase the money supply, not to worry them about inflation when it is not yet necessary. By the following January the real GDP should be back on track. In the long run the the government will pay off the deficit, and maybe even before that the bank will have to increase interest rates to slow down the economy, even without the G factorof the equation. Also, in the long run—we’re all dead!

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