Question

Explain the difference between “active” discretionary fiscal policy advocated by mainstream economists and “passive” fiscal policy advocated by new classical economists. Explain: “The problem with a balanced-budget amendment is that it would, in a sense, require active fiscal policy—but in the wrong direction—as the economy slides into recession.”

Short answer

The active discretionary fiscal policy advocated by mainstream economists is to stop the deepening of the recession. While the passive fiscal policy advocated by new classical economists is about not adopting the fiscal policy in case of instability.

The statement means that the balanced-budget amendment leads the economy in the wrong direction by using active fiscal policy because balancing the budget fuels inflation and deepens the recession.

Step-by-step solution

Explanation of the difference in views

The mainstream economists advocate a fiscal policy to cure the instability. At the same time, the new classical economists believe that no such policy is needed. However, the economy will be self-corrected to its full-employment output. Thus, the former defends discretionary policy and suggests activating the policy in times of recession or inflation.

Explanation of the statement

The balanced budget amendment refers to the balancing of the budget by equation total expenditures to total receipts. The statement states that a balanced budget amendment would require an active fiscal policy.

When in a recession, the government revenue will be low. So, the government will have to increase taxes and reduce government spending to achieve the balance. Doing so will achieve the balance, but it will further aggravate the recession problem, as the purchasing power will worsen with the policy. So, it is said that the problem with the balanced budget amendment is that it pushes the economy in the wrong direction.