GDP, Fiscal Policy, and the Business Cycle Explained

Introduction

This memo addresses three issues commonly discussed when talking about the economy. First, it explains how gross domestic product (GDP) can be used to measure the business cycle. Second, it describes the roles of the government bodies responsible for determining national fiscal policies. Third, it explains how national fiscal policies impact the economy's production and employment — specifically, how changes in government spending and taxation affect economic output. Considered together, these three explanations should lead to a better understanding of fiscal policy at a national level.

GDP as a Measure of the Business Cycle

Gross domestic product (GDP) is the monetary value of all finished goods and services produced in a country within a specific time period, usually each year. It includes all items, whether produced or consumed publicly or privately, and is a measure of production rather than consumption. For example, a car manufactured in 2011 but sold in 2012 would be included in 2011's GDP, not 2012's. This is an important distinction because, while GDP is used as a proxy measure for the business cycle and for the financial health of a country, production and consumption are not the same and should not be confused.

The problem with GDP as an economic indicator is that it is often used incorrectly. GDP data frequently emphasize exchange instead of production. GDP is represented as the sum of consumer spending, housing and business investment, net exports, and government purchases. Behind this accounting façade, however, lies a more complex reality: "GDP is generated by individual labor combined with both proprietors' and business capital, raw materials, energy, and technology in a myriad of different industries" (Anderson, 2002). One reason for this disconnect is that, on its own, GDP is not a strong measure of continued economic health. Goods are produced in anticipation of consumption; therefore, goods produced in a specific year are based on economic projections. In an economic downturn, those produced goods may not be exchanged, which can lead to excess supply and actually exacerbate economic troubles.

Government Bodies and Fiscal Policy

There are a number of different government bodies responsible for determining national fiscal policies. They fall into two broad groups: government bodies and the Federal Reserve Bank. The government has several entities that help formulate fiscal policy, including the President and his administration and Congress. The Office of Management and Budget (OMB) is the executive department in charge of fiscal policy-making, as well as ensuring that fiscal policies align with other national priorities. The OMB handles "budget development and execution, a significant government-wide process managed from the Executive Office of the President and a mechanism by which a President implements decisions, policies, priorities, and actions in all areas (from economic recovery to health care to energy policy to national security)" (The White House, 2012). More specifically, the Budget Review Division examines data and engages in trend analysis to help determine the appropriate pathway for budgetary decisions.

While the OMB is, admittedly, a biased organization whose fiscal policies are linked to the President's broader policy agenda, the congressional body responsible for fiscal analysis is theoretically non-partisan. The Congressional Budget Office is a non-partisan organization that conducts analysis of economic policy. However, these analyses are then used by partisan members of Congress to help outline potential economic policies for the country.