Question

Some states are required to balance their budgets. Is this measure stabilizing or destabilizing? Suppose all states were committed to a balanced-budget philosophy and the economy moved into a recession - what effects would this philosophy have on the ability of the state to stimulate the economy?

Answer 1

Whilst an economy enters an economic downturn, governmental deficits augment as taxation revenues fall & governmental expenditure on programs like unemployment insurance rise. These ‘automatic stabilizers’ are immensely essential as they cushion the blow to the economy from a depression. Having these systems in place to soak up recessionary shocks is one of the significant economic advances of the last eighty years. To comply with a Balance budget approach as a slump approached, Congress would have to counterbalance any mechanical rise in the deficit thru augmentation of taxes or cutting expenses. The augmented taxes or expenditure cutbacks would further pull down the economy, raising the deficit yet again & needing still more taxation increases / spending cutbacks. This vicious cycle would intensify the harm to the economy. Fundamentally this vicious cycle would cause a big increase in the fiscal multiplier, with every dollar in spending cutbacks leading to output losses of nearly $2.50.