# Policy Making11. Technical workshop I

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.

##### 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.

##### 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.