The Technical Workshop reviews the theory behind fiscal policy.
Fiscal policy and economic theory: a recap
Say the government wants to stimulate the economy by increasing government expenditures. There will be an immediate effect on aggregate demand. Recall the equation for aggregate demand:
Y = C + I + G + (Ex - Im)
where Y is total nominal income or output, C is consumption, I investment, G government spending, Ex exports and Im imports (all in real terms). Accordingly, an increase in G causes Y to go up.
But will the increase in Y last? Bring in aggregate-demand and supply analysis to answer the question. Figure 33-3 shows the Keynesian argument for a positive effect of an increase in government spending. Aggregate demand moves out and with the aggregate supply curve upward sloping, output (Y) goes up, and so does the price level.
Figure 33-3 The effect of a stimulative fiscal policy according to the Keynesian model
Caption: An increase in government spending has a multiple effect on aggregate demand because of the multiplier effect. Aggregate demand shifts to the right. With an upward sloping and stable aggregate supply curve, income, y, will go up. But so does the price level.
Concept Check 3: Keynesian theory predicts that when government spending goes up by 10 billion dollars, aggregate demand goes up by a multiple amount of 10 billion. What is the reasoning behind the prediction? (From Chapters 24 and 25.) (Answer at end of chapter.)
Answer: The Keynesian consumption function is that consumption responds to changes in current income. Additional government spending generates new income; new income generates more consumption; more consumption generates more income; and so on. This is the so-called multiplier effect of fiscal policy.
Concept Check 4: Why is the slope of the aggregate supply curve critical for the final effect of fiscal policy? (Hint: What happens if the curve is vertical? Horizontal? Answer at end of chapter.)
Answer Concept Check 4: If the aggregate supply is horizontal, a shift in aggregate demand will have maximal effect on output. A vertical aggregate supply curve, by contrast, precludes any desired effect; only the price level changes. In the intermediate case (an upward-sloping aggregate supply curve) both output and the price level go up when fiscal policy stimulates aggregate demand to move outward.
Concept Check 5: How does a decrease in taxes affect aggregate demand? (Answer at end of chapter).
Answer: A decrease in taxes increases disposable income for consumers. Consumption goes up and sets the multiplier process into motion. Aggregate demand goes up.
Concept Check 6: How does the inclusion of the financial sector in the Keynesian model contribute to a partial crowding out of fiscal policy. (From Chapter 30. Hint: What is the key "price" in the financial sector? Answer at end of chapter.)
Answer: In the financial sector the interest rate is the key "price." When the government increases spending, its deficit increases. The deficit has to be financed, which leads to higher interest rates (notice that the model assumes that the bond market is not international). The higher interest rates will discourage private spending. This is the "crowding out" effect: public spending will at least partially crowd out private spending because of the effect on interest rates.
Monetarists and new classicals consider fiscal policy to be ineffective. For one thing, they say that the shift in aggregate demand will be small because 1) the multiplier effect is minimal and 2) the need to finance the federal deficit forces up the interest rate and thereby "crowds out" private investment (as discussed in Chapter 25.)
Their more powerful counterargument, however, involves the supply side of the economy. As Figure 33-4 shows, monetarists and new classicals see the aggregate supply curve shift to the left in reaction to the cut in taxes. The end result of an expansionary fiscal policy, therefore, is 1) the return of real output to its original (natural) level and 2) an increase in the price level. Thus, in their view, fiscal policy is ineffective.
Figure 33.4 In the new classical and monetarist model the aggregate supply curve shifts in response to fiscal changes
Caption: When fiscal policy leads to change in aggregate demand the workers alter their price and wage expectations. The result is a shifting aggregate supply curve, until equilibrium output has returned to its "natural" level.
Concept Check 7: In the new classical and monetarist scenarios, why does the aggregate supply curve shift in response to the cut in taxes? (From Chapter 28. Answer at end of chapter.)
Answer: The aggregate supply curve shifts because of adjusting expectations--workers will expect prices to go up because of the stimulus program and will demand higher nominal wages. Whether the expectations are adaptive or rational matters only for the length of the adjustment. With adaptive expectations workers will take some time to catch up, during which time fiscal policy can be effective. If their expectations are rational, though, their response is immediate, at least so long as workers are anticipating the policy change.
Keynesians maintain that fiscal policies will be effective as long as the economy operates below capacity (or its 'natural' level). In that case interest rates will not go up much in response to an increase in the government deficit, and workers will refrain from asking higher nominal wages as many of them are still unemployed. The aggregate supply curve will not shift to the left, or only will do so very slowly. Real output, therefore, will be up after the implementation of the fiscal measure, and so will employment.