When fiscal policy might make matters worse

From the new 4th edition of Cowen and Tabarrok, Modern Principles of Economics:

Increased spending and tax cuts have to be paid for. Thus, increased spending and tax cuts today will tend to be followed by decreased spending or tax increases tomorrow. When tomorrow comes and spending is reduced and taxes rise, aggregate demand will fall—this is one reason why long-run or net multipliers are smaller than short-run multipliers. Ideal fiscal policy will increase AD in bad times and pay off the bill in good times, as we show in Figure 37.5. Overall, if we can spend more in bad times when the multiplier is big and tax more in good times when the multiplier is small, the net effect will lead to higher GDP overall. Economists say that the ideal fiscal policy is counter-cyclical because when the economy is down the government should spend more, and when the economy is up the government should spend less.

Although counter-cyclical fiscal policy makes sense to economists, it often
doesn’t make sense to politicians or to voters. The views of economists violate a kind of “common sense” or folk wisdom, which says that in bad times the government should spend less and only in good times should the government spend more. After all, you and I spend less when times are bad and more when times are good, so shouldn’t the government behave similarly? If the government follows the “common sense” view, however, it will tend to make recessions deeper and booms larger, thereby making the economy more volatile, again as shown in Figure 37.5.

Even when governments do spend more in recessions, as economists suggest, they often don’t follow through on the second half of the prescription, which is to spend less during booms…This usually means that there is less room for expansionary fiscal policy when it is needed.

The 4th edition is just out, here is more information.


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