Fiscal Policy and Crowding Out

Instructor: Alex Tabarrok, George Mason University

Effective fiscal policy has to be timely, targeted, and temporary . But how the central bank , businesses, and consumers respond to fiscal policy also plays a role

Effective fiscal policy has to be timely, targeted, and temporary. But how the central bank, businesses, and consumers respond to fiscal policy also plays a role in how effective it is.

When expansionary fiscal policy is enacted, what happens to the aggregate demand curve? It shifts out with the goal of increasing real GDP growth in the short run. But inflation also increases. Can you think of how a central bank might respond to higher inflation? Yep, they might contract the money supply through monetary policy.

So one way that fiscal policy can be offset is by the actions of a central bank. Now let’s think about how businesses and consumers might respond to expansionary fiscal policy.

If the government has increased its spending through borrowing, interest rates in the loanable funds market tend to be higher for consumers. If you’re a business owner, you might think twice about investments that would require a loan. Decreased investment has a negative effect on overall real GDP growth, partially offsetting fiscal policy.

What if the government uses tax cuts in its stimulus plan? You may decide to not spend that extra money, thinking that a tax cut today might be matched by a tax increase in the future. That’s good planning! If enough people think this way and save their tax cuts, this will completely crowd out the fiscal multiplier.

In reality, this particular scenario is unlikely. Think about it – do you incorporate your future (and unknown) tax burden into your financial decisions today? Probably not. Most people tend to not be quite that future-oriented. But it’s not safe to assume that everyone will just spend all of their tax cuts either.

As you can see, there are quite a few unknowns when it comes to how a stimulus will be received. A thorough understanding of the models is crucial for successful fiscal policy, as is context for the economic situation in which they will be implemented.

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In order to work well, fiscal policy must be timely, targeted, and temporary, as we discuss in our previous video. But fiscal policy can also be fully or partially offset depending on how central banks, businesses, and consumers respond to fiscal policy.


First: central banks. When a government increases spending, the aggregate demand curve shifts out, which increases inflation. Now, central banks often try to stabilize prices. So, if fiscal spending shifts the aggregate demand curve out, increasing inflation, the central bank might choose to contract the money supply. Contracting the money supply means shifting the aggregate demand curve inwards. In other words, monetary policy could offset or reverse the fiscal policy expansion. When a central bank responds to expansionary fiscal policy with contractionary monetary policy, we call this a monetary offset.


But it's not just the central banks that respond to changes in fiscal policy -- businesses could also act in ways that partially offset a fiscal stimulus. For example, if the government increases spending by borrowing, this will tend to increase the interest rate in the loanable funds market. And if the interest rate increases, businesses may scale back on their investment. So, remember that real GDP is consumption plus investment plus government spending and net exports. So, when "G" increases, we may see a decrease in "I," investment, offsetting the fiscal stimulus and weakening the effects of the multiplier. Consumers could also respond to fiscal policy in ways that make fiscal policy less effective. If the government cuts taxes to stimulate the economy, people might then choose to save the tax cut.


Now, saving money from a tax cut actually makes a lot of sense if people expect that tax cuts today will be matched by tax increases tomorrow. However, if people save their tax cuts instead of spending them, then the aggregate demand curve never shifts out. The multiplier will be zero, and there will be no systematic macroeconomic effects. Now this scenario is sometimes called Ricardian equivalence, after the 19th-century British economist, David Ricardo. Most economists think that it's somewhat unrealistic to model everyone as fully rational and incorporating their future tax burdens when making saving and spending decisions. Tyler claims that he never behaves in this way, though I'm not so sure that's true.


Some people, however -- they are very future-oriented. And most people -- they think a little bit about the future when making spending decisions. So Ricardian equivalence probably describes some people, maybe not most people. In any case, to the extent that Ricardian equivalence reflects how people plan, tax cuts will be less effective as fiscal stimulus than they otherwise would be.


Okay, summing up. Fiscal policy is complicated, because it's not just a matter of increasing government spending -- we also have to take into account how central banks, investors, and consumers respond to fiscal policy. Moreover, how people respond to fiscal policy isn't mechanical. It depends upon their evaluation of the economic situation and their expectations about the future. So, the same fiscal policy can have different effects in different historical situations. Good economic policy therefore requires both an understanding of the models but also an understanding and an appreciation of the actual situation. Thus, economic policy is both science and art.

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