Thursday, December 27, 2007

Essay on Balanced Budget in Keynesian Theory

According to Keynesian economics, what impact would a balanced budget amendment to the constitution requiring the federal government to balance its budget annually have on the economy?

In an ideal economy there is rapid growth of output per worker (productivity), low unemployment and low inflation. However, in the typical business cycle there is a fluctuation from expansion to peak, to recession, to trough and then to a growth trend again. Before I address the question, I need to clarify what a balanced budget means to me. This term can be looked upon through different lenses and perspectives. One lens may be to regulate government spending based on set tax revenue that is received. In other words: reduce government spending while in a deficit and refund government tax revenue surplus. Another perspective is to increase taxes while in a deficit and reduce taxes when in a surplus. The next perspective would be to use a combination of government spending and taxes to keep the budget balanced. I will briefly discuss one aspect of each scenario. Because the topic is broad, I will narrow my discussion to focus on the effects of when the economy is in a recession and the budget is in deficit.

I will begin by outlining the basics of Keynesian economics. Keynesian economics states that the aggregate supply curve is relatively horizontal in nature. It states that when the economy is operating at less than full employment, then as the GDP grows, prices and wages will stay the same. Keynesian theory also states that "demand creates its own supply (page 306)." Now, let's couple this with the first scenario of the government keeping a balanced budget. The first scenario suggested that if the government is in a deficit then government spending would be cut and vice versa. I would like to make a premise and an assumption here by theorizing that if demand creates its own supply, as Keynesian economics states, then the economy will never reach full employment. If the economy is in recession, Keynesian economics states that in order for a recovery, government policy must be employed. The government would thus have to spend to bring the economy out of recession. But what happens if the government has already spent over the budget? The balanced-budget policy would require the government to cut spending. This would go directly against Keynesian theory of government having to spend in order to recover from a recession. The idea of keeping a balanced-budget, in this case, would be counter-productive and would send the economy into a deeper recession. By cutting government spending, GDP would decrease by the government spending multiplier. Furthermore, as government cuts spending, unemployment would rise; there would be less personal disposable income and less tax revenue to the government and more cuts in government spending. This would turn into a terrible downward spiral.

Now, let's look at the next scenario of increasing taxes while in a deficit and the economy is in a recession. This, again, would prove to be counter-productive because if the government raises taxes, then there would be less personal disposable income. Less income translates to less consumption; the GDP would decrease, thus throwing the economy deeper into recession. The tax multiplier happens to be less than the government spending multiplier, thus the effect would not be as devastating as cutting government spending. However, there still would be a chain reaction; as GDP decreases there will be less tax revenue to the government. Less tax revenue would again put the budget into deficit and the government would be faced with raising taxes again or decreasing government spending. From here, you probably get the idea, a deadly spiral downward.

The last scenario of increasing government spending and taxes in the time of a recession and while the government is in deficit is the most interesting to me. Since the balanced budget multiplier is equal to 1, then it is possible for the government not to spend more than its tax revenue, while at the same time increase GDP. This, of course, would be over the long run and would take longer than government spending and operating in a deficit. The interesting fact is that a balanced-budget policy would require the government not operate in a surplus as well. Government spending would be limited and the GDP would be stifled.
My conclusion would be that a balanced-budget policy would not be productive to our economy. The government needs the flexibility to make effective decisions and be allowed to operate in a deficit when necessary in order to pull the economy out of a recession. A balanced-budget policy would be counter-productive to the health of our economy.

Posted on Tuesday, April 8, 2003 at 01:46AM by Juan David De Jesus