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Government and the Economy, Promoting Full Employment and Price Stability

discretionary fiscal policy, cyclical unemployment, unemployment falls, famous episodes, tax programs

In addition to the monetary policies of the Federal Reserve System, the federal government can also use its taxing and spending policies, or fiscal policies, to counteract inflation or the cyclical unemployment that results from too much or too little total spending in the economy. Specifically, if inflation is too high because consumers, businesses, and the government are trying to buy more goods and services than it is possible to produce at that time, the government can reduce total spending in the economy by reducing its own spending. Or the government can raise taxes on households and businesses to reduce the amount of money the private sector spends. Either of these fiscal policies will help reduce inflation. Conversely, if inflation is low but unemployment rates are too high, the government can increase its spending or reduce taxes on households and businesses. These policies increase total spending in the economy, encouraging more production and employment.

Some government spending and tax policies work in ways that automatically stabilize the economy. For example, if the economy is moving into a recession, with falling prices and higher unemployment, income taxes paid by individuals and businesses will automatically fall, while spending for unemployment compensation and other kinds of assistance programs to low-income families will automatically rise. Just the opposite happens as the economy recovers and unemployment falls—income taxes rise and government spending for unemployment benefits falls. In both cases, tax programs and government-spending programs change automatically and help offset changes in nongovernment employment and spending.

In some cases, the federal government uses discretionary fiscal policies in addition to automatic stabilization policies. Discretionary fiscal policies encompass those changes in government spending and taxation that are made as a result of deliberations by the legislative and executive branches of government. Like the automatic stabilization policies, discretionary fiscal policy can reduce unemployment by increasing government spending or reducing taxes to encourage the creation of new jobs. Conversely, it can reduce inflation by decreasing government spending and raising taxes. .

In general, the federal government tries to consider the condition of the national economy in its annual budgeting deliberations. However, discretionary spending is difficult to put into practice unless the nation is in a particularly severe episode of unemployment or inflation. In such periods, the severity of the situation builds more consensus about what should be done, and makes it more likely that the problem will still be there to deal with by the time the changes in government spending or tax programs take effect. But in general, it takes time for discretionary fiscal policy to work effectively, because the economic problem to be addressed must first be recognized, then agreement must be reached about how to change spending and tax levels. After that, it takes more time for the changes in spending or taxes to have an effect on the economy.

When there is only moderate inflation or unemployment, it becomes harder to reach agreement about the need for the government to change spending or taxes. Part of the problem is this: In order to increase or decrease the overall level of government spending or taxes, specific expenditures or taxes have to be increased or decreased, meaning that specific programs and voters are directly affected. Choosing which programs and voters to help or hurt often becomes a highly controversial political issue.

Because discretionary fiscal policies affect the government’s annual deficit or surplus, as well as the national debt, they can often be controversial and politically sensitive. For these reasons, at the close of the 20th century, which experienced years with normal levels of unemployment and inflation, there was more reliance on monetary policies, rather than on discretionary fiscal policies to try to stabilize the national economy. There have been, however, some famous episodes of changing federal spending and tax policies to reduce unemployment and fight inflation in the U.S. economy during the past 40 years. In the early 1980s, the administration of U.S. president Ronald Reagan cut taxes. Other notable tax cuts occurred during the administrations of U.S. presidents John Kennedy and Lyndon Johnson in 1963 and 1964.

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