Fiscal policy has something known as action lag. This is the time it takes for fiscal policy actions to be proposed, approved, and implemented.

Fiscal policy and monetary policy are the two main tools used to achieve macroeconomic goals such as stable prices and economic growth. Fiscal policy influences the economy through government spending and taxation decisions. Monetary policy, managed by the central bank, affects the economy by controlling the supply of money and setting interest rates. Together, they help smooth out economic fluctuations and promote long-term growth.

Turner is correct because an increase in government spending has a direct and full impact on aggregate demand, while an equivalent increase in taxes has a smaller negative impact, as only a portion of the tax increase reduces consumption (the rest affects savings). This is due to the marginal propensity to consume (MPC) being less than one. Therefore, the net effect on real GDP is positive. Reed is incorrect because the offsetting effect of higher taxes is weaker than the stimulative effect of higher government spending.

Keynesian economics, developed by John Maynard Keynes, argues that markets do not always quickly self-correct during downturns. In particular, during recessions, private sector demand may be too weak to return the economy to full employment. Therefore, Keynesians advocate for active government intervention—especially through increased government spending and tax cuts—to boost aggregate demand, stimulate economic growth, and lower unemployment.

Automatic stabilizers, such as unemployment insurance and progressive income taxes, help moderate economic fluctuations without the need for new legislative action. During a recession, tax revenues fall and government spending on support programs rises, leading to a budget deficit. During economic expansions, higher incomes increase tax revenues and reduce spending on social programs, often leading to a budget surplus. This countercyclical effect helps smooth out the ups and downs of the business cycle.

The effectiveness of discretionary fiscal policy depends heavily on proper timing. If fiscal measures, such as tax cuts or increases in government spending, are delayed, they could hit the economy after conditions have already changed—potentially making economic instability worse rather than better. Well-timed policy changes can dampen recessions or slow overheating economies, stabilizing growth and inflation.

When an economy is producing below its potential GDP, running a fiscal deficit through higher government spending or tax cuts can help boost aggregate demand, leading to higher output and employment. This Keynesian view sees deficits as a useful short-term tool during economic slowdowns. In contrast, concerns about future tax burdens and the crowding-out of private investment (higher interest rates due to government borrowing) are arguments for being cautious about deficits, not against.

The crowding-out effect and concerns about slower long-term economic growth are common reasons for worrying about large fiscal deficits. Increased government borrowing can push up interest rates, discouraging private investment, and future tax hikes to repay debt could weaken economic growth. However, Ricardian equivalence—the idea that households will increase savings now in anticipation of future taxes—implies that deficits have little to no impact on overall demand, and thus is not a strong reason to be concerned about the deficit’s size.

Ricardian equivalence suggests that when the government runs a fiscal deficit, rational households anticipate that future taxes will rise to pay off the government debt. As a result, they save more now to prepare for the higher future tax burden. This increase in private savings offsets the stimulus effect of deficit spending, leaving aggregate demand largely unchanged. Thus, according to this theory, fiscal deficits may not boost economic activity as much as traditional Keynesian economics would suggest.

An increase in short-term interest rates signals contractionary (or restrictive) monetary policy. The central bank is attempting to reduce the growth of money and credit in the economy, making borrowing more expensive and saving more attractive. This slows economic activity and helps control inflation. In contrast, expansionary monetary policy involves lowering interest rates to stimulate borrowing, spending, and investment.