If the federal government were required to balance the budge

If the federal government were required to balance the budget each year, would this have a positive or a negative impact on the economy? Why?

Solution

Economy does not remain in static conditions. It is, in fact, remains in dynamic realm. It goes through different phases of business cycle. Each phase of business cycle require different policy prescription. Monetary authorities use monetary policy and government use fiscal policy for formulating such policy prescriptions.

For example, when economy is going through recession, government generally administers expansionary fiscal policy or undertake budget deficit which implies increase in government expenditure or decrease in taxes. This stimulates the aggregate demand and put the economy back on recovery path as well as reduces the severity of recession as well.

On the other hand, when economy is on expansionary path, inflation tends to rise. Sometimes at very rapid pace. In such scenario, government administers contractionary fiscal policy or undertake budget surplus which implies decrease in government expenditure or increase in taxes. This leads to decrease in aggregate demand and tames inflation.

If government is required to balance the budget then government will become handicapped with respect to its response to changing economic situation.

In this scenario, during recession or during situation of high inflation, lack of government response will make matter worse and will have severe negative impact on the economy.

In fact, lack of government action can delay the recovery from recession by a considerable time period which can severely damage the standard of living of country concerned.

Thus, if the federal government were required to balance the budget each year, a negative impact would be experienced on the economy.