Fiscal Policy in the United States

Fiscal policy is the process the government uses to determine the appropriate level of taxes and spending necessary to deal with recessions, inflation, and unemployment. This is accomplished by the government deliberately making changes "...in either government spending or taxes to stimulate or slow down the economy" (Colander, 2004, p. 583). The methods used to accomplish such are identified as expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy can be used to bring an economy out of a recession, and contractionary fiscal policy can be used to reduce real output to fight inflation. The way these tools are used, as well as the possible need for their use in the current economy, will be discussed in further detail in the following pages.

Expansionary Fiscal Policy

Expansionary fiscal policy is an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. The goal of expansionary fiscal policy is to close a recessionary gap, stimulate the economy, and decrease the unemployment rate. A good example of how expansionary fiscal policy works is through wars. During wars, government spending increases significantly, this causes a decrease in unemployment and a rise in the GDP. Unfortunately, this also causes an increase in the government deficit. World War II is a good illustration of the effect of expansionary fiscal policy.

World War II

In 1940, the year before the United States entered the war, the U.S. unemployment rate was at 14.6 percent, the GDP was at $99 billion dollars, and the deficit was $-2.7 billion dollars. In 1941, with the bombing of Pearl Harbor and the entry of the United States into World War II, the federal government mobilized its resources and increased spending. This caused the deficit to increase to $-4.8 billion dollars, but also caused unemployment to drop to 9.9 percent and the GDP to rise to $124 billion dollars. As government spending and the deficit increased to $-19.4 billion dollars in 1942, the unemployment rate further dropped to 4.7 percent, and the GDP rose to $157 billion dollars. This pattern continued over the next 2 years; so that in 1944 the deficit was at $-46.1 billion dollars, unemployment was at a record low of only 1.2 percent, and GDP was $210 billion dollars.

The example of the economic rise during World War II might make it seem like wars are always good for the economy. While they do bring about expansionary policy, increase GDP, and decrease unemployment, they also bring several negative effects. For instance, during World War II many people went without many goods such as butter; and although unemployment decreased, much of this was a result of people being killed or permanently disabled.

Contractionary Fiscal Policy

Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. It is the practice of decreasing government purchases of goods and services, increasing net taxes, or some combination of the two for the purpose of decreasing aggregate demand and thus controlling inflation. The goal of contractionary fiscal policy is to close an inflationary gap, restrain the economy, and decrease the inflation rate.

When the government spends less than the amount of tax revenues, there is a budget surplus and the deficit is reduced. This decrease in spending also leads to a decrease in output, which will then lead to higher unemployment and a decrease in aggregate spending. When the government increases taxes it leaves households with less disposable income that can be used for consumption expenditures; which then reduces aggregate production and employment and leads to further decreases in income, thus reducing inflationary pressure.

Another contractionary fiscal