Chapter 30, Problem 2CYU

To determine

The reason behind the phenomenon that why states that balance their budgets due to constitutional obligation are more prone to evidence severe economic fluctuations as compares to other states which do possess any such obedience.

Explanation of Solution

Making it mandatory to maintain a balanced budget each year would weaken the automatic stabilizing effects of taxes and transfers. Recessions are kept to a minimum in size by the propensity of tax collection to decline and transfers to increase as the economy declines. However, a fiscal deficit is being created by increased transfer payments and declining tax receipts. The government would be forced to react to this imbalance with contractionary fiscal measures if the balanced budget rule were to apply, which would likely cause the recession to worsen.