Fiscal Policy Stabilization

Fiscal policy is a tool for economic stabilization primarily because as we have seen above, it has the capacity to affect output, that is, GDP (Weil). Thus, for example, an expansionary fiscal policy increases aggregate demand, which in turn results to increased output and increased prices. Nevertheless, it has to be remembered that the extent with which increased aggregate demand increases output and prices depends on the status of the business cycle (Weil).

If the economy is in recession, which means that economy has “unused productive capacity” and a number of unemployed workers, then increased aggregate demand would result to increased demand without necessarily changing price levels. An economy that is in “full employment,” on the other hand, would not necessarily result to an increased output from an expansionary fiscal policy, apart from increased prices.

In instances when the economy needs stabilizing such as during recession or in times of boom (and hence periods of high inflation), fiscal policy provides the means to restore stability, albeit imperfectly. During times of recession, an expansionary fiscal policy is put in place to “restore output to its normal level and to put unemployed workers back to work” (Weil). In times of boom, on the other hand, a contractionary fiscal policy is put in place to curb inflation by slowing down the economy (Weil). In these instances, fiscal policy is countercyclical.

Actually, countercyclical fiscal policy measures are inherent in the current economic system of the country such that there are automatic stabilizers that automatically function during moments when stability is needed. These stabilizers are “programs that automatically expand fiscal policy during recessions and contract it during booms” (Weil). Weil mentions two of these stabilizers. The first is unemployment insurance “on which the government spends more during recessions (when the unemployment rate is high)” (Weil).

Thus, this unemployment insurance automatically expands fiscal policy in moments when unemployment rate is high and the economy is in recession. The second automatic stabilizer mentioned by Weil is taxes. Since taxes (assuming that the tax system is progressive) are proportional with wages and profit, an increase in wages and profit mean an increase in taxes as well. Thus, this means increased taxation, a contractionary fiscal policy measure, during moments of boom.