Answer
See explanation
Work Step by Step
Some politicians have proposed the idea of implementing a constitutional amendment in the United States that would compel the Federal government to maintain a balanced budget each year. It's important to understand that if such an amendment were strictly enforced, it would necessitate the government to adopt a contractionary fiscal policy whenever the economy faced a severe recession.
Monetarists, in particular, strongly oppose expansionary fiscal policy, contending that deficit spending associated with such policies tends to "crowd out" private investment. When the government runs a deficit by borrowing from the public, it competes with private businesses for available funds. This increased demand for money leads to higher interest rates and, in turn, reduces private investment, which would have otherwise been profitable. As a result, the overall impact of a budget deficit on aggregate demand remains uncertain and, at best, limited.
Real-business cycle (RET) economists reject discretionary fiscal policy for similar reasons as they reject active monetary policy—believing it doesn't work. They argue that businesses and labor would quickly adjust their behavior in anticipation of the price-level effects of changes in fiscal policy, causing the economy to move directly to the expected new price level. Like monetary policy, according to RET theorists, fiscal policy can only affect inflation in the long run because its effects are fully anticipated. In the short run, fiscal policy cannot alter real GDP significantly. Consequently, they advocate for a balanced government budget as the optimal course of action.
However, it's important to note that tax revenues tend to decline sharply during recessions and rise rapidly during periods of demand-pull inflation. Therefore, a law or constitutional amendment mandating an annually balanced budget would necessitate the government to increase tax rates and reduce government spending during recessions, which would worsen economic downturns. Conversely, it would require reducing tax rates and increasing government spending during economic booms, which could fuel inflation. This approach could have adverse effects on economic stability and counter the usual fiscal responses to economic cycles.
