Understanding How the Government Stimulates the Economy

A constant subject of debate and concern in the political arena, the economy remains to be a highly debated topic. Stimulating the economy is accomplished in one of two ways. The government can increase government spending or decrease taxes.

Essentially, in the short term, increased spending will stimulate the economy much faster than tax reductions. It is imperative to remember that government spending to stimulate a slow economy is not free. Eventually, the choice to increase spending leads to its consequences. Increasing government spending may be necessary in the short run in a slow economy, but it will lead to less investment spending by individuals and businesses as well as slower potential long-term growth.

All government spending, even for necessary expenses like military equipment, needs to be viewed in this light. Any money spent by the government must be accounted for either by increasing taxes, increasing debt, or reducing spending in some other area of the government. However, economic stimulation through tax reductions is more effective in the long term because tax reductions also stimulate investment, which government spending does not do.

Fiscal policy is the plan by the government to influence the economy by using it as a component in aggregate demand and using its ability to drain the economy through taxes. The government uses three tools of fiscal policy to influence the economy. The tools are taxes, government spending and transfer payments.

Taxes help the government influence the amount of goods and services purchased by the general public. Government spending refers to the purchase of goods and services by the government, and direct payments are payments from the government to the general public for benefits like unemployment and Social Security.

When government spending changes, aggregate demand is directly affected by the full amount in the change in spending. If the government increases spending aggregate demand will be directly affected by the increase. If the demand increases, prices will rise until supply and demand are again at equilibrium. The new equilibrium and GDP will be increased by an amount equal to the increased spending.

Both of the tools, taxes and government spending, will stimulate the economy; however, tax cuts put dollars in the hands of American citizens rather than in Uncle Sam's pockets.

A tax cut means the average taxpayer will have to pay less money to the government. This may seem like an obvious statement, but the reality of the words needs to be considered. As a result, every household in America will have an increase in their disposable income. Each household will have more money. Basically, this is similar to a raise.

Furthermore, because Americans will have more money, they will be able to afford to purchase more of the things they want. The added funds that were being spent in taxes can now be used for a vacation, a new car, or other purchases that may have seemed out of the question. An increase in disposable income will result in a rise in consumption.

Because the general public will have more money to spend, more jobs will be created to keep up with the demand of products and services. A rise in consumption affects aggregate demand.

Another long term benefit which needs to be mentioned is that the increase in consumer demand will result in more jobs, which will increase the equilibrium output. As supply rises, prices will fall. This means a long term benefit of a tax cut is that prices will drop.

Again, the government has two tools to stimulate the economy-- that is, increased government spending or implementing tax cuts. While many Americans strongly emphasize their support for a candidate who will choose the general public over the government, the general public needs to understand that tax reductions, leading to more government borrowing, have the same crowding-out effect as spending does. So this is not the perfect solution either, though it is better than government spending.

America needs an ally of the public who will clearly explain the complicated matters of the economy rather than the quintessential politician who claims to be able to achieve lofty goals without stating how the goals will be accomplished.