Spending Cuts Deepen a Downturn

Spending Cuts Deepen a Downturn, step by step

1. 1

   Already below potential

   The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output and a recessionary gap is already open. The deficit looks alarming partly because of that weakness: a slack economy collects less tax and pays out more in transfer payments. Lawmakers decide to attack the deficit anyway.

2. 2

   A large cut in government spending

   Government spending (G) is a component of aggregate demand, so a sharp cut in government purchases shifts AD left. The spending multiplier works in reverse: canceled contracts cut firms' revenue, those firms cut payrolls, and the households that lose income cut consumption, so the total fall in aggregate demand is a multiple of the cut itself. Production costs have not changed, so SRAS stays exactly where it is.

3. 3

   A deeper recessionary gap

   AD crosses the unchanged SRAS at a much lower price level and a much lower real GDP, further from the full-employment level marked by LRAS than where the economy started. The recessionary gap has widened and unemployment climbs further above its natural rate. Contractionary policy applied to an already-weak economy does not merely fail to help. It pushes output in the wrong direction, which is what procyclical fiscal policy looks like on this graph: the budget moves with the cycle instead of against it.

4. 4

   Why the deficit may not shrink

   Cutting spending in a slump shrinks the deficit by less than the arithmetic promised. Lower incomes mean less income and payroll tax collected, and more households qualify for unemployment benefits, so revenue falls and transfer payments rise as output drops. The automatic stabilizers push back against the discretionary cut. None of that budget arithmetic shows up on the AD/AS graph, which plots only the price level and real GDP.

5. 5

   Why timing makes this so hard

   Fiscal policy runs on lags. First comes a recognition lag while the data arrive, since GDP is reported late and then revised, and then an administrative lag while a bill is drafted, argued over and passed. Last comes an implementation lag while the money is actually spent or the cut takes hold. By the time policy lands the economy may be somewhere other than where lawmakers aimed, which is how a cut meant for a boom arrives in a slump.

Where it ends up

A large cut in G shifts AD left by a multiple of the cut, so the price level falls and real GDP falls further below potential, deepening the recessionary gap the economy already had.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• Benefits Rise as Layoffs Spread →
• Highway Program in a Recession →
• Household Income Tax Increase →

More Fiscal Policy (AD-AS) walkthroughs

• Infrastructure Spending Fights a Recession →
• Spending and Taxes Rise Together →
• Tax Cuts and the Tax Multiplier →
• A Payroll Tax Increase Cools Spending →
• Automatic Stabilizers in a Downturn →