The chief argument against using discretionary fiscal policy to combat recessions emphasizes the long lags involved in changing fiscal policy in the U.S. Legislated fiscal actions taken since January 2001 reduced the standardized surplus by 0.5% of GDP in 2001 and will reduce it by a projected 1.2% of GDP in 2002. It illustrates the swing in discretionary fiscal policy since 2000, with the standardized surplus falling from 1.3% of GDP in 2000 to a projected deficit of 0.8% of GDP for 2002. Figure 1 shows the standardized surplus based on the Congressional Budget OfficeвЂ™s (CBO) April 2002 projections. The standardized surplus provides a good way to measure these discretionary changes by correcting the actual budget surplus for changes due to the effects of automatic stabilizers. Expansionary fiscal policy aims to boost demand and output in the economy either directly, through greater government expenditures, or indirectly, through tax reductions that stimulate private consumption and investment spending.

In addition to the automatic responses of fiscal policy, governments may make discretionary fiscal changes in the face of an economic downturn. State and local governments also see their tax revenues fall during recessions, but, because many of these governments must balance their budgets annually, they often must cut spending during recessions. While the automatic adjustments of federal spending and taxes work to stabilize the economy, not all automatic fiscal adjustments are stabilizing. Auerbach and Feenberg (2000) have estimated that automatic tax stabilizers offset about 8% of the impact of an economic shock to GDP. Similarly, tax payments decline automatically when the economy goes into a recession. This increase in spending is automatic in that it does not require explicit actions by Congress or the President. For example, during an economic slowdown, government spending on unemployment benefits rises automatically as the unemployment rate rises. This Economic Letter discusses some of the issues involved in using fiscal policy to help stabilize short-run fluctuations in the economy.ДЄutomatic stabilizers and discretionary fiscal policyДЄs economic activity fluctuates, fiscal expenditures and taxes respond automatically in ways that stabilize the economy. The current recession and the 1990-1991 recession offer contrasting examples of the use of fiscal policy, and they also highlight some elements of the longstanding debate in economics over whether fiscal policy can play a useful role in combating business cycle downturns. In contrast, during the current recession, both Congress and the President have supported increases in expenditures and tax cuts as ways to stimulate economic growth, culminating in the passage of the Economic Recovery Act in March 2002. In fact, his Council of Economic Advisers, in their February 1992 report, argued that increases in fiscal expenditures or reductions in taxes might hamper the economyвЂ™s recovery. Bush resisted attempts to use fiscal policy to stimulate the economy. recession, in 1990, then President George H. This active use of fiscal policy during a recession is somewhat unusual.

The federal government budget has swung from a surplus of $236 billion in 2000 (2.5% of GDP) to a projected 2002 deficit of $157 billion (1.5% of GDP) as the government has increased expenditures and reduced taxes. Fiscal policy also has become more expansionary. Since January 2001, the Federal Reserve has reduced its benchmark policy interest rate, the federal funds rate, from 6.52% in September 2000 to a current level of 1.75%. This sluggish economic performance comes despite substantial stimulus from both monetary and fiscal policy. Adding some gloom to the general outlook, the stock market continued to drop through most of July and has remained volatile. Unemployment, after rising throughout 2001, has leveled off but has yet to show signs of declining. During the second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%, well below market expectations. economy from the recent recession is on a bumpy path.

In recent weeks, a number of signs have appeared suggesting that the recovery of the U.S. Can fiscal expansions be contractionary?.Automatic stabilizers and discretionary fiscal policy.

Examples of automatic stabilizers