Fiscal policy in the long run

In the short run discretionary fiscal policy, government spending, tax cuts and transfers, can be used to address recessionary and inflationary gaps. Regardless of what specific choices are made, what matters for the yearly budget of the government is how funds collected compare to funds paid out.

$$\begin{array}{r}\text{Deficit}=T-G-\text{Transfers}<0\\ \text{Surplus}=T-G-\text{Transfers}>0\end{array}$$

The government budget is often compared to a household budget. On a surface level that comparison can work, when thinking about a single year. However, the government chooses their own income and prints the money that the income is paid in. So that analogy has significant weaknesses in long-term discussions, and one that is best left out of our discussions.

Although it is mostly skipped over at this level, transfers do make budget deficits increase. There is also mixed evidence that transfers act as a stimulus in practice. The $MPC$ of one time payments does seem to be lower than it is for regular income, although it is not zero.

Cyclical versus structural deficits

A cyclical deficit is the portion of the deficit that comes about due to natural changes in the government budget situation without any legislation changes. So as the economy enters a recession, tax receipts fall and expenditures on programs such as unemployment benefits rise. $TR$ goes up and $T$ falls, both of which make the deficit worse. From a balanced budget, that would make a deficit appear and from an existing deficit, it would make it a larger negative number.

A structural deficit is the part of the deficit that would exist even if the economy were at full employment. In this situation, tax revenue is chosen to be lower than government spending. This results from policy choices and prioritization, not the economic situation. Although we will not dig into this, it is worth mentioning that part of the structural deficit is interest payments on the national debt, the accumulation of past deficits. In the US these have risen from just over 11% at the end of 2019 to 16.2% at the end of 2025.

Structural deficits can be a significant limiter to growth, because the solutions are to cut spending, raise taxes or print money. Cutting government spending or raising taxes shift the $AD$ curve right and lower output and increase unemployment. The potential effects of printing money to pay deficits will be discussed in the next section.

Policy lags

Discretionary policy is generally larger than automatic stabilizers, and has been used when a larger impact is required. However all forms of discretionary policy, fiscal and monetary, suffers from three lags in causing a shift in the $AD$ curve.

Definitions

Recognition lag

The time lost in realizing there is an economic problem that requires a response

Decision lag

The time spent designing and deliberating on specific policies

Implementation lag

Once policy is chosen, the time required for the policy to impact the real economy.

Recognition lag is unavoidable, and can be longer or shorter depending on the nature of the economic issues requiring a policy response. For reference, the Great Recession is dated as having started in December of 2007, but it was not broadly recognized until the Global Financial Crisis in September of 2008. The recession stemming from COVID-19, however, was declared pre-emptively in March of 2020, quicker than it could show up in any data.

Decision lag is the main weakness of fiscal policy. For the Great Recession, the primary stimulus bill, the American Recovery and Reinvestment Act, was not passed until February of 2009. It was also negotiated to be smaller than the original proposal. Meanwhile for COVID, the CARES Act was passed at the end of March 2020, and ended up larger than the original proposal.

Implementation lag is relatively short for many types of fiscal policy. Things such as stimulus checks or tax rebates may be relatively quick once bills are passed. Direct government spending is often slower, with money being spread out over longer periods. Tax cuts can also be slower, not being fully realized until taxes are filed the following April 15th.

Side effects of deficits

There are three ways to pay for new spending or tax cuts. The government can raise taxes, print money or issue debt, usually in the form of bonds.

Raising taxes by an equal amount does not change the deficit, but it also reduces the expansionary effect of the spending. In many countries and US states this is often a legal requirement, usually a balanced budget amendment to the constitution. Such laws are pushed to promote fiscal responsibility, but they reduce flexibility to respond to economic crises and recessions.

In 2025 the government deficit was $1.77 trillion, 5.6% of GDP. If the government raised no tax revenue at all and only printed money to pay for its purchases, it would require a 31% increase in M2. This is not something that an economy can sustain for multiple years. Printing money to pay for deficits like this has been a significant cause of historical episodes of hyperinflation.

Raising taxes reduces the economic stimulus of new spending. Especially to reduce a deficit created by tax cuts, it does not make sense in the slightest. Even for new spending, if the government raises taxes in an equal amount, all it does is cancel out the multiplier effect of the spending.

So usually borrowing is the preferred option to finance a deficit, especially when the deficit is due to a policy response to a recession. If the government borrows to finance new spending, transfers or a tax cut, they do so in the bond market. So while those changes increase $AD$, they also can raise interest rates. This makes borrowing more expensive and leads to lower investment.

This effect that government deficits have on interest rates, and the corresponding fall in investment is called crowding out. Because of this if $G$ or transfers rise or if $T$ falls, this makes the government budget deficit larger. This change in the deficit requires additional borrowing, which “uses up” some of the supply of loanable funds, shifting it to the left.

As a result the equilibrium level of $I$ decreases and the final increase on $AD$ is smaller than intended. Private investment is reduced to “make room” for more government borrowing. Showing this graphically in the loanable funds market is not a requirement, but the concept is one that may show up in a MCQ or as a piece of a FRQ.

If a country’s government runs a surplus, as is the case in many recent years in Germany, that has the opposite effect. A surplus makes the government a saver, and in a closed economy that shifts the supply of loanable funds to the right. This makes interest rates lower and increases the equilibrium level of investment.