Question

Some politicians have suggested that the United States enact a constitutional amendment requiring that the federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experiences a severe recession.

Short answer

An expansionary fiscal policy to cure recession will create a budget deficit. Therefore, the government will have to enable the contractionary fiscal policy to maintain the budget whenever the economy faces a recession.

Step-by-step solution

Meaning of recession

A recession is a phase of the business cycle when economic activities take a downturn. The economy experiences a slowdown in aggregate spending and output due to a decline in aggregate demand. As a result of the recession, unemployment rises, and the recession accelerates further.

An economy falls into recession after a continued slow growth or decline in the output over several months, at least a quarter of the year. The government needs to push the aggregate demand forward by increasing its expenditure to overcome this, leading to a budget deficit.

Reason for contractionary fiscal policy in a recession

A mandatory requirement to maintain the budget annually will stop the government from pursuing an expansionary policy.The only option left to overcome recession is that the government leaves more money in the people's hands to encourage consumption. This requires a reduction in taxes and an increase in transfer payments, unemployment allowances, and other spending to accelerate production and growth.

The federal government will have to alter its expansionary fiscal policy to maintain its budget annually. Therefore, a contractionary fiscal policy becomes mandatory whenever the economy faces a high recession; otherwise, there will be a budget deficit.