Keynesian Stabilization Policy, Automatic Stabilizers, and Fiscal Implications of the Zero Lower Bound

An alternative to the tax-smoothing approach is the Keynesian approach to stabilization policy. According to the Keynesian approach, higher government spending or lower taxes during a recession may speed up the recovery.

As we saw in chapter 15, Keynesian models would prescribe that deficits should be countercyclical, that is, increase in recessions and become surpluses in booms. However, there is no reason such cyclical deficits should lead to a secular increase in government debt-to-output ratios. Increases in government purchases during recessions could be compensated by discretionary spending cuts during booms, leading to constant government debt to output ratios over the business cycle. Such policies have similar effects in new Keynesian DSGE models as well.

However, there are important counterarguments against this traditional Keynesian fiscal prescription. The main counterargument is the existence of long and variable lags in the design, implementation, and effects of changes in fiscal policy.¹ These lags are particularly important and relate to delays in the recognition of the need for a fiscal stimulus, the political discussion of it, the implementation of the necessary adjustments through the legislative budgetary process, and the ultimate realization of its macroeconomic effects. Such lags also arise in the case of monetary policy, but they are much longer in the case of fiscal policy, as the budgetary process is a long and drawn out political process compared to the relatively swift decision making process for monetary policy. Therefore, by the time a fiscal stimulus is enacted, it may be too late and may even prove counterproductive.

Thus, even for someone who otherwise accepts the theoretical arguments in favor of discretionary Keynesian fiscal policy, the fact that monetary policy is more flexible than fiscal policy (because it has shorter decision and implementation lags) could be reason enough to prefer monetary over fiscal policy. However, in cases where monetary policy has hit the zero lower bound, a more convincing argument can be made for countercyclical changes in fiscal policy.²

In any case, even with constant tax rates and expenditure plans, the fiscal system acts in a stabilizing way. This takes place through the operation of the so-called automatic stabilizers. If tax rates are constant (say, because of tax-smoothing considerations), a decline in economic activity reduces aggregate tax revenue and causes fiscal deficits to rise. Government expenditure also increases, because of automatic rises in expenditure for social programs, such as unemployment insurance. Hence, deficits rise in recessions and decline in booms, exerting a stabilizing influence through aggregate demand, even without discretionary changes in fiscal policy.

The operation of automatic stabilizers is consistent with tax-smoothing theories and is an additional reason as to why government deficits and government debt rise in recessions and decline in booms. An additional role for discretionary changes in fiscal policy may arise in cases where monetary policy has hit the zero lower bound.

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