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Fiscal policy in the short run

Explain the goals and tools of fiscal policy.

Distinguish between automatic stabilizers and discretionary fiscal policy and understand how the budget deficit is measured.

Use the IS–MP model to explain the challenges of using fiscal policy effectively.

Use the IS–MP model to understand how fiscal policy affects the economy in the short run.

Explain how fiscal policy operates in an open economy.

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Learning Objectives
After studying this chapter, you should be able to:
13.1
13.2

13.3

13.4

13.5

Driving toward a “fiscal cliff”

In mid-2012, finding a job was very difficult.

Employment was nearly 10 million jobs below its normal level.

Why?

Severity of recession of 2007-2009.

Fears about increased taxes and spending cuts (the “fiscal cliff”) convincing employers that expanding was unwise.

Fiscal policy became particularly contentious within government during President Barack Obama’s first term in office.

American Recovery and Reinvestment Act of 2009 (“the stimulus package”) involved spending increases and tax cuts designed to aid recovery after the recession.

But it certainly added to already large budget deficits.

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During the 2007–2009 recession, Congress and the president undertook unprecedented fiscal policy actions.

Was the American Recovery and Reinvestment Act of 2009 successful at increasing real GDP and employment?

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Key Issue and Question

Issue:

Question:

Fiscal policy in the short run

In this chapter, we use the IS-MP model to explain how fiscal policy affects the economy in the short run.

Fiscal policy Changes in federal government taxes, purchases of goods and services, and transfer payments intended to achieve macroeconomic policy objectives.

We will see that fiscal policy can encounter problems in achieving its goals.

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Explain the goals and tools of fiscal policy.

13.1

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Learning Objective

The goals and tools of fiscal policy

Great Depression of the 1930s was the worst economic downturn in U.S. history.

Fearing another economic downturn after WWII, Congress and President Truman enacted the Employment Act of 1946:

“The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means… to promote maximum employment, production, and purchasing power.”

For the first time, government was taking explicit responsibility for macroeconomic goals.

Fast forward to recession of 2007-2009.

Government took policy action such as American Recovery and Reinvestment Act to reduce the severity of the recession.

What actions did the government take? And were they appropriate?

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Who conducts fiscal policy?

Central government makes taxation and spending decisions in most countries.

U.S. Congress and president debate federal policies.

State and local government actions not generally considered fiscal policy.

Typically lack a national impact.

Policy decisions related to other issues may impact spending.

Not considered fiscal policy if direct goal is not macroeconomic in nature.

Military actions.

Environmental policy.

Focus is generally on employment and production, leaving price stability to the central bank.

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Traditional tools of fiscal policy

Fiscal policy can have short-run macroeconomic effects by changing aggregate expenditure.

Three fiscal policy tools that affect real GDP.

Government purchases

Taxes

Transfer payments

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Fiscal policy tool #1: Government purchases

Government spending on a broad range of goods and services.

Computers.

Military equipment.

Economic research.

Infrastructure such as roads and bridges.

Increases in G, holding all else fixed, increase aggregate expenditures.

Increased expenditure, leads to increased sales at firms.

Increased sales increases production.

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Increase G

Increase AE

Increase real GDP and employment

Fiscal policy tool #2: Taxes

Taxes come from different sources:

Income tax

Corporate income tax

Payroll tax

These three are levied by the U.S. government

Consumption/sales tax

Common in many countries, most states

U.S. government does collect some excise taxes on particular goods, like alcohol and cigarettes.

Value-added tax

Common in Europe; paid on the difference between price and cost

Changes in taxes affect consumption and investment components of aggregate expenditure.

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Effect of taxes on consumption

Changes in personal income taxes raise or lower disposable income.

Reducing tax rates raises disposable income.

Save or consume additional income.

Disposable income National income plus transfer payments minus personal tax payments.

Governments often cut personal income taxes to fight recessions.

Example: Economic Growth and Tax Relief Reconciliation Act of 2001 reduced tax rates.

Taxes on consumption through sales or VAT taxes impact consumption, by making those goods more expensive; mechanism is similar to income taxes.

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Increase in disposable income

Increase in C

Increase in AE

Increase in real GDP and employment

Decrease in personal income tax rate or consumption tax rate

Effect of taxes on investment

Changes in corporate tax rates impact the after-tax profitability of investment projects.

Firms may decide certain projects are no longer profitable if corporate tax rates increase.

Governments often cut corporate taxes to fight recessions.

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Decrease in corporate tax rate

Increase in after-tax profitability of investment projects

Increase in I

Increase in AE

Increase in real GDP and employment

Fiscal policy tool #3: Transfer payments

Changes to transfer payments impact disposable income.

Unemployment insurance limits decline in disposable income from job loss.

Governments often extend transfer payments to those who lose jobs during recessions.

During the 2007-2009 recession, unemployment benefits were granted for extended durations.

Federal government augmented state unemployment benefits for up to 99 weeks.

Note: Unemployment benefits are state programs in the U.S.

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Increase in transfer payments

Increase in disposable income

Increase in C

Increase in AE

Increase in real GDP and employment

Expansionary policy and contractionary policy

Expansionary fiscal policy is intended to increase real GDP and employment by increasing aggregate expenditures.

Increase government purchases.

Reduce tax rates.

Increase quantity or duration of transfer payments.

Contractionary fiscal policy is intended to reduce increases in aggregate expenditures that seem inflationary.

Reduce government purchases.

Increase tax rates.

Reduce quantity or duration of transfer payments.

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The severity of the 2007-2009 recession

Why was the severity of the 2007-2009 recession so hard to predict?

Obama administration presented forecasts of real GDP and unemployment in early 2009 that turned out to be much too optimistic.

But other policymakers, economists, and CEOs were also surprised by the severity of the recession.

The recession turned out to be the worst since the Great Depression:

One reason was that there had been no financial crises in the U.S. since the 1930s—economists had little recent experience with them.

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Making the Connection

The severity of the 2007-2009 recession

Carmen Reinhart and Ken Rogoff of Harvard University gathered data on recessions accompanied by bank panics/crises throughout the world. The table shows the effect of these recessions on the countries they involved.

The recession of 2007-2009 appears typical in this light.

If policymakers and economists had anticipated the financial crisis and realized what happens to economies during financial crises, they might have been able to anticipate the severity of the recession.

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Making the Connection

Distinguish between automatic stabilizers and discretionary fiscal policy and understand how the budget deficit is measured.

13.2

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Learning Objective

Discretionary policy

Discretionary fiscal policy Government policy that involves deliberate changes in taxes, transfer payments, or government purchases to achieve macroeconomic policy objectives.

Discretionary policy can be expansionary or contractionary.

Expansionary discretionary fiscal policy attempts to increase employment and real GDP.

Example: 2009 American Recovery and Reinvestment Act.

Contractionary discretionary fiscal policy attempts to reduce inflation.

Example: 1968 10% surcharge on personal and corporate income to reduce expenditures and prevent accelerating inflation.

This is rare; combatting inflation is usually left to the Federal Reserve.

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Automatic stabilizers

While discretionary fiscal policy is intentionally changed in response to macroeconomic conditions, some types of spending and taxes do this automatically.

Automatic stabilizers Taxes, transfer payments, or government expenditures that automatically increase or decrease along with the business cycle.

Unexpected events—”shocks”—result in fluctuations in real GDP.

These are accentuated by the multiplier effect.

Automatic stabilizers help to reduce the severity of these fluctuations.

Example: Unemployment insurance payments increase automatically during a recession, partially offsetting the effect of the recession. They also automatically decrease during expansions.

Example: Income tax payments are lower during recessions and higher during expansions.

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The budget deficit and the budget surplus

Budget deficit The situation in which the government’s expenditure is greater than its tax revenue.

Budget surplus The situation in which the government’s expenditure is less than its tax revenue.

The federal budget surplus and deficit, 1901-2011

Figure 13.1

The graph shows the U.S. federal budget surplus or deficit as a percentage of GDP. Deficits tend to be large during wars and during recessions.

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Budget surplus in the late 1990s and early 2000s

The federal government ran budget deficits of over $1 trillion from 2009 through 2012.

But in the late 1990s and early 2000s, it actually ran a budget surplus!

Before 1998, the federal government had not had a surplus since 1969. Why did it have a surplus in 1998-2001?

No recession since 1990-1991, resulting in 89% increase in tax receipts.

Budget Enforcement Act of 1990 placed limits on federal expenditures and (nominally) created a “pay-as-you-go” rule.

Reduction in defense spending (end of Cold War)

“Welfare reform” resulted in fewer families qualifying for welfare.

Tax increases under Bush (1990) and Clinton (1993).

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Making the Connection

Budget surplus in the late 1990s and early 2000s

What ended the surpluses?

Recession in 2001—automatic stabilizers

Reductions in taxes (“Bush tax cuts”) in 2001, 2003

Increase in defense and national security spending after September 11, 2001 terrorist attacks

Budget deficits have continued to grow, resulting in high levels of government debt.

U.S. federal government debt in 2012 exceeded the value of U.S. GDP.

Should we be concerned about the high debt?

Debt above 90% of GDP is associated with a decrease in growth of 1.2%.

High debt results in higher taxes and lower spending.

However U.S. government can currently borrow at historically low rates.

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Making the Connection

The budget deficit and the budget surplus

The federal budget surplus and deficit, 1901-2011

Figure 13.1

In isolation, the size of a budget deficit or surplus can be misleading because of automatic stabilizers. That is, the long-run budget situation may be substantially different from the short-run budget situation.

Example: the current (2012) budget deficit is large; but it is exacerbated by the increased expenditure on automatic stabilizers due to the severe recession of 2007-2009.

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If, by the time you are teaching this, the budget deficit is under control, please feel free to rewrite this. 

Full-employment budget deficit

What would the budget deficit be if the economy were at full employment?

Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if real GDP equaled potential GDP; also called the full-employment budget deficit or surplus.

We can break a budget deficit down into its causes:

Budget deficit = Cyclically adjusted budget deficit + Effect of automatic stabilizers

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Cyclically adjusted budget deficit in various countries

Comparing the cyclically adjusted budget deficit across countries is a good method to explore international differences in discretionary fiscal policy.

Cyclically adjusted budget deficit or surplus for Japan, the U.K, the U.S, and countries using the euro, 1994-2011

Figure 13.2

Recall that budget deficits are expansionary, and budget surpluses are contractionary.

Discretionary fiscal policy may have contributed to the recession in 2001, for example, by moving to being more contractionary.

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Cyclically adjusted budget deficit in various countries

Also notice that, despite high deficits in many European countries, they have a relatively small cyclically-adjusted budget deficit.

Cyclically adjusted budget deficit or surplus for Japan, the U.K, the U.S, and countries using the euro, 1994-2011

Figure 13.2

This is because European countries tend to rely more on automatic stabilizers (unemployment benefits etc.) than does the United States.

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Did fiscal policy fail during the Great Depression?

Recovery after the Great Depression was very slow; and some economists believe this was because the federal government did not do enough through fiscal policy to encourage recovery.

The table shows that the federal government generally had a budget deficit after the Great Depression; but it had a cyclically adjusted budget surplus.

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Macro Data

Did fiscal policy fail during the Great Depression?

A consequence of the Great Depression was a substantial change in macroeconomic thought.

Modern macroeconomics analysis largely began with John Maynard Keynes’s 1936 book The General Theory of Employment, Interest, and Money.

Conclusion drawn by many economists from the book: expansionary fiscal policy would be essential to pull the U.S. out of the Great Depression.

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Macro Data

The deficit and the debt

When the federal government runs a budget deficit, the U.S. Treasury borrows funds from investors by selling Treasury securities (“bonds”). During a budget surplus, the Treasury pays off some existing bonds.

U.S. federal debt held by the public as a percentage of GDP, 1790-2011

Figure 13.3

Gross federal debt held by the public Debt that includes the debt securities issued by the U.S. Treasury (and a small amount of securities issued by federal agencies) not held by the federal government; also called national debt.

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The deficit and the debt

Increases in the ratio of the national debt to GDP have typically occurred due to wars or major recessions.

The ratio has generally decreased during peacetime, as GDP has grown faster than the debt.

U.S. federal debt held by the public as a percentage of GDP, 1790-2011

Figure 13.3

This pattern has changed somewhat over the last few decades, with the 1980s and 2000s seeing large budget deficits due to increased spending and tax cuts.

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Is the federal debt a problem?

Debt can be a problem for a government for the same reasons it can be a problem for a household or business:

Affording payments on debt require cutting back on other spending

Inability to make payments results in defaulting on the debt

In 2011, interest payments were about 6% of total federal expenditures.

At this level, large tax increases or significant spending cutbacks are not required.

In the long run, a large debt-GDP ratio could pose a problem.

If interest rates rise, investment spending may be crowded out.

Lower investment spending would result in lower capital stock, reduced capacity to produce goods and services.

This effect is somewhat offset if government spending on infrastructure, education, and research and development increase productivity.

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Use the IS–MP model to understand how fiscal policy affects the economy in the short run.

13.3

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Learning Objective

Fiscal policy during the recession of 2007-2009

Governments can use fiscal policy to reduce the severity of economic fluctuations.

For example, from 2008 to 2009, the global economy experienced declines in output and employment. Governments responded by reducing taxes and/or increasing spending, hence making budget deficits larger.

Euro-zone countries relied mostly on automatic stabilizers, while other rich countries used more discretionary measures.

Fiscal policy in advanced economies, 2008-2009

Table 13.1

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Fiscal policy and the IS curve

Changes in fiscal policy shift the IS curve.

Expansionary changes shift it to the right, resulting in higher equilibrium real GDP.

Contractionary changes shift it to the left, resulting in lower equilibrium real GDP.

Fiscal policy tools and real GDP

Table 13.2

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Using fiscal policy to fight a recession

Suppose the economy is initially at point A: a recession, with real GDP below potential.

Expansionary fiscal policy could shift the IS curve to the right; restoring full employment.

Any of the expansionary fiscal policies on the previous slide could achieve this goal.

Note that this would result in higher inflation than would have occurred.

Discretionary fiscal policy to end a recession

Figure 13.4

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Using fiscal policy to fight a recession

The American Recovery and Reinvestment Act of 2009 (“the stimulus package”) was intended to do just this after the 2007-2009 recession.

It consisted of:

Increases in transfer payments

Increases in government purchases of goods and services

Tax cuts to households and firms

Aid to state and local governments to offset their budget problems.

China enacted a similar stimulus package in 2009.

Discretionary fiscal policy to end a recession

Figure 13.4

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Automatic stabilizers

Automatic stabilizers reduce the size of the multiplier.

Any shock, positive or negative, will have less of an effect than it otherwise would.

Darrel Cohen and Glen Follette: automatic stabilizers in the U.S. reduce the size of the multiplier by about 10%, a relatively modest reduction.

The expansionary effect of automatic stabilizers varies from recession to recession, depending on policies in place, and the severity of the recession.

Automatic stabilizers and a decrease in aggregate expenditure

Figure 13.5

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Should government eliminate the budget deficit?

The U.S. has run large budget deficits recently, resulting in large increases in the national debt.

Some people have suggested the federal government ought to “balance its budget”, eliminating deficit spending. Debate about budget deficits intensified during 2012, with the presidential election.

Use the IS-MP model to analyze the effect on the output gap and employment if the government eliminated a budget deficit when real GDP was below potential GDP.

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Solved Problem

Should government eliminate the budget deficit?

Step 1 Review the chapter material.

Step 2 Draw the IS-MP model with the economy experiencing a negative output gap. The equilibrium should occur where real GDP is less than potential.

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Solved Problem

Should government eliminate the budget deficit?

Step 3 Determine the effect on the IS curve of eliminating the budget deficit. To eliminate the deficit, purchases and/or transfers must decline, and/or tax revenue must increase. Any of these changes would be contractionary, shifting the IS curve to the left.

Step 4 Draw the IS-MP graph with the new IS curve. The output gap increases in size; real GDP and employment fall further below potential.

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Solved Problem

State/local government spending during recession

The 2007 recession resulted in the worst decline in state and local tax revenues since World War II, and increased demand for public services.

Budget deficit totaling $200 billion or 30% of total spending.

Balanced budget requirements meant immediate cuts to spending or increased taxes.

State employees furloughed to save money.

California furloughed 200,000 workers on Fridays in 2008.

Led to employees and families cutting back on expenditures.

Research by Joshua Aizenman and Gurnain Pasricha shows positive effects from the 2009 federal American Recovery and Reinvestment Act were offset by negative effects of state and local governments cutting spending and raising taxes.

Total increase in spending was only $47.6 billion between 2008 and 2009.

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Making the Connection

Personal income tax rates and the multiplier

Changes in tax rates differ from changes in dollar amounts.

Marginal income tax rates are the fraction of each additional dollar of income that must be paid in taxes.

With tax rates of 20%, only 80% of each dollar of income remains.

Disposable income is reduced by taxes.

Consumption is based on disposable income:

where MPC is the marginal propensity to consume, and is autonomous consumption.

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Personal income tax rates and the multiplier

Aggregate expenditures after accounting for income tax rate:

In equilibrium, we have:

Therefore:

Implying:

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Personal income tax rates and the multiplier

Suppose investment changes, while the other autonomous terms remain unchanged:

We can divide by to find the multiplier for investments:

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Personal income tax rates and the multiplier

Suppose the MPC is 0.75, and there is a 0% income tax rate:

That is, an increase in investment would result in a four times larger increase in real GDP.

If the tax rate increased to 20%:

Now the same change in investment increases real GDP by only 2.5 times as much—a smaller multiplier effect; but the same is true for a decrease also.

We have demonstrated that income taxes serve as an automatic stabilizer for the economy, by reducing the multiplier.

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The formula is identical for changes in autonomous consumption, government purchases, and net exports.

Calculating equilibrium real GDP and multiplier

Assume the Fed is keeping the real interest rate constant. Use the following data to calculate the equilibrium level of real GDP and the value of the investment expenditure multiplier.

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Solved Problem

Calculating equilibrium real GDP and multiplier

Step 1 Review the chapter material.

Step 2 Use the data to calculate equilibrium real GDP. Using the equation for equilibrium (Y = AE), and substituting in our values (in trillions of dollars):

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Solved Problem

Calculating equilibrium real GDP and multiplier

Step 3 Calculate the value of the multiplier from the data given. The multiplier formula from earlier is:

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Solved Problem

The effects of changes in tax rates on potential GDP

Potential GDP is determined by the quantity of labor, the quantity of capital, and the level of efficiency in the economy.

Income taxes are calculated as a percentage of income, and hence drive a wedge between what employers pay and what employees receive.

Tax wedge The difference between the before-tax and after-tax return to an economic activity.

Economists generally believe that the smaller the tax wedge for any economic activity, the more of that activity will occur.

Example: Workers might decide how much to work based on their after-tax hourly wage. A smaller income tax rate results in a higher hourly wage, and hence more labor provided.

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The effects of changes in tax rates on potential GDP

Some specific taxes have significant effects on potential GDP:

Individual income taxes Lower individual income tax rates would increase incentives to:

Supply labor

Save (since returns to savings are taxed at individual income tax rates)

Start new businesses (since sole proprietorship profits are taxed similarly)

Corporate income taxes

Lower corporate income tax rates would potentially increase:

Investment (by increasing the return to investment)

Innovation (similarly)

Taxes on dividends and capital gains

Dividends are profits corporations distribute to shareholders; capital gains are the change in the price of an asset. Lowering tax rates on each of these encourage investment in these assets, making more funds available to firms, leading to a higher capital stock and greater potential GDP.

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Supply-side economics

Decreases in tax rates of the nature described on the previous slide could lead to increases in capital, labor, and the overall level of efficiency.

These are known as supply-side effects of fiscal policy.

While most economists believe these effects are real, there is debate over the size of the effects.

Example: Increases in the quantity of labor supplied may not be large in response to a income tax rate cut.

Ultimately, this is an empirical debate.

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Use the IS–MP model to explain the challenges of using fiscal policy effectively.

13.4

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Learning Objective

The limitations of fiscal policy: policy lags

Just like for monetary policy, fiscal policy faces some limitations.

The three policy lags present for monetary policy are also present for fiscal policy:

Recognition and implementation lags

Discretionary fiscal policy requires coordination between Congress and the president, introducing potentially significant lags—first in recognizing the need for action, then in agreeing upon an action.

Automatic stabilizers, by contrast, take effect immediately.

Impact lags

These can range from several months to several years for fiscal policy.

Example: Corporations may take a long time to decide upon and then implement new projects in response to a corporate tax rate cut.

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Policy lags and the stimulus package

The table shows CBO estimates from 2009 of the impact of the American Recovery and Reinvestment Act of 2009.

While most of the tax cuts took place relatively quickly, some of the expenditure increases were projected to take longer to take place.

Some debate surrounding the stimulus package centered around the lack of “shovel-ready” projects funded.

Initial estimates of the timing of government expenditure and tax changes from the American Recovery and Reinvestment Act

Table 13.3

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Economic forecasts and modeling

The lags associated with fiscal policy mean Congress and the president must rely on economic forecasts.

Sometimes these forecasts are inaccurate.

Underestimating the impact of a shock may lead to a recession.

Overestimating impacts of shocks can lead to overproduction, unnecessary deficits, or inflation.

Federal Reserve Bank of Philadelphia predicted

Real GDP to fall by 0.2% in 2009, actual decline was 2.6%.

Unemployment to rise to 7.4%, actual increase to 10.0%.

The impact of policy depends on the size of the fiscal policy change, and the size of the multiplier. The latter varies with the type of policy, and cannot be known with certainty, as the estimates on the next slide demonstrate.

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Multiplier estimates

Estimates of the multiplier from various academic and government sources

Table 13.4

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Crowding out

Crowding out may help explain why multipliers are not large.

Crowding out A reduction in private investment expenditures caused by government budget deficits.

Deficits impact ability for households and firms to borrow.

Increased government deficit reduces national savings.

Result is higher real interest rates.

Crowding out partially offsets expansionary fiscal policy.

Degree of crowding out depends on who finances deficit and how much interest rates change.

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The forward-looking hypothesis

Most economists believe households and firms are forward-looking:

Look to the future when deciding about consumption and investment.

Households and firms care about taxes today and in the future.

Ricardian Equivalence is the idea that households reduce consumption when the government cuts taxes because they are forward looking.

Multiplier could be reduced all the way to zero.

When government cuts taxes today, people believe future taxes will have to increase to offset tax cuts.

Households save some (or all) of the tax cut proceeds to pay future taxes.

Increased savings to pay future taxes leads to consumption today rising by less than cut in taxes.

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When will fiscal multipliers be large?

More likely to be large during severe recessions.

Size of multiplier depends on ability of firms and households to use additional revenue.

If economy is at full employment, increased government purchases may divert resources from other needs

During recession, there are substantial unemployed resources.

Multipliers are more likely to be large if the central bank can keep real interest rates constant.

Crowding out has potential to raise real interest rates, offsetting effect of increased spending.

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Moral hazard

Fiscal policy can create moral hazard.

Insulation from consequences of poor decisions, making them more likely.

Could create more severe fluctuations.

The Emergency Economic Stabilization Act in 2008 created the TARP program.

$700 billion helped keep some firms from failing.

Citibank, AIG, Chrysler, General Motors, BofA.

Sends a signal that the government will save firms from bankruptcy if they are large and important.

Firms benefit from risky decisions that pay off.

Government bears the burden of risky decisions that go poorly.

How did the government seek to combat moral hazard associated with TARP?

Restricted ability of firms to pay dividends until funds repaid.

Enforced limits on executive compensation to reduce potential benefit from risky actions.

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Consequences of policy limitations

2009 U.S. output gap was 7.2%, or about $1 trillion.

To close the output gap using fiscal policy depends on the size of the multiplier.

High multiplier of 2.5? $1 trillion / 2.5 = $400 billion

Multiplier of 1.0? $1 trillion / 1.0 = $1 trillion

Multiplier of 0.6? $1 trillion / 0.6 = $1.7 trillion

Low multiplier of 0.4? $1 trillion / 0.4 = $2.5 trillion

Uncertainty exists about the size of government spending increases or tax cuts to end recessions.

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Evaluating the American Recovery and Reinvestment Act

President Obama’s economic team forecast the unemployment rate would not rise over 8% if the ARRA was passed.

Opposing interpretations for why this did not happen:

The ARRA did not increase real GDP and employment.

The act worked as intended, but the recession was much more severe than forecast.

Which of these views is correct?

Studies suggest the act raised real GDP; but these studies are generally based on large multiplier estimates.

Second approach: compare historical paths for real GDP and employment with forecasts of GDP and employment assuming the act had not been passed.

But this approach cannot distinguish between the effect of the stimulus package and other (e.g. Fed) actions.

There is no current consensus on how effective the stimulus package was.

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Explain how fiscal policy operates in an open economy.

13.5

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Learning Objective

Fiscal policy with floating exchange rates

Expansionary fiscal policy leads to inflation pressure; the Fed combats this inflation pressure by raising interest rates.

This would ordinarily decrease consumption and investment, partially offsetting the fiscal policy. Now net exports will decrease also.

Fiscal policy in an open economy

Figure 13.6

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Fiscal policy with a fixed exchange rate

With a floating exchange rate, we saw that expansionary fiscal policy is less effective than in a closed economy.

With a fixed exchange rate, it is actually more effective than in a closed economy. Why?

In order to support the fixed exchange rate, the central bank must keep the real interest rate constant.

Therefore the usual offsetting by the central bank cannot occur.

Of course, this also means the fiscal policy will have stronger effects on inflation.

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Answering the key question

“Was the American Recovery and Reinvestment Act of 2009 successful at increasing real GDP and employment?”

In the short run, fiscal policy affects aggregate expenditure, which in turn causes changes in real GDP and employment.

Increases in government purchases and transfers should increase real GDP and employment.

Decreases in taxes should also increase real GDP and employment.

ARRA performed both of these; but economists have not yet come to a consensus as to how effective they were.

Depends on the multipliers for expenditures and taxes, which may be smaller than government economists have assumed.

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