From Raj Nallari and Breda Griffith's lecture notes.
Fiscal Policy and its Impacts
Through its decisions on fiscal policy, government can attempt to smooth business cycles and redistribute income. While these are good goals, overreaching on the fiscal side can lead to crowding out and inflation. Today we discuss these important issues.
Fiscal policy and the business cycle
Fiscal policy can help smooth the business cycle through its impact on aggregate demand (AD) .The change in AD is typically greater than the initial change in government expenditure because of the so-called multiplier effect. The government may use expansionary fiscal policy by raising government expenditures (G) or lowering taxes to increase output or aggregate demand. Business responds to the increased demand for their goods and services by increasing business investment. As businesses invest more, they hire more workers, increasing employment. There are now more workers with a paycheck and their spending creates an increase in AD for goods and services. Businesses respond to the increased AD for their products by increasing business investment. As businesses invest more, they hire more workers and increase employment and so on (the multiplier effect). With contractionary fiscal policy, the opposite happens. The appropriate fiscal policy stance for an economy depends on the economic situation and time frame. While short-run fiscal policy may aim at smoothing the business cycle, over the long run the aim of fiscal policy should be to keep the deficit at a low and stable level to help underpin economic growth. (As we shall discuss, high and sustained deficits lead to crowding out, inflation and/or balance of payments problems.) In developing countries, under good macroeconomic conditions, the government may also pursue higher public spending as part of a poverty reduction strategy.
Crowding Out, Inflation and other Deficit Effects
Unchecked increased government spending or the pursuit of expansionary fiscal policies to promote output and economic growth can impose a cost on the economy in terms of increased inflation and/or crowding out of private sector investment. Under expansionary fiscal conditions, at some point inflation is likely to rise as AD (spending) outstrips the aggregate (total) supply (AS) of goods and services. Under such conditions, businesses can hardly keep up with orders and respond to the 'excess' demand by raising their prices. Under tight labor market conditions, employers may also be forced to raise wages in order to attract new workers and retain old workers. This can also be looked at from the financing side. Sustained high fiscal deficits, if financed by the central bank printing money, will set the stage for higher inflation. Sustained higher government spending can also lead to crowding out of private investment. If, for example, government chooses to finance its deficits by borrowing in the bond market or from private banks, rather than the central bank, interest rates will increase of the conditions for private sector bank lending will be mad more difficult. Either way, private investment will likely be hurt under such conditions. By contrast, low and stable levels of the fiscal deficit send a positive message on a government’s ability to service its debt and thus may prevent the probability of economic crises. Macroeconomic stability associated with the low probability of economic crises yields further benefits in terms of higher rates of investment, growth, educational attainment, increased distributional equity and reduced poverty (Gavin and Huasmann, (1998), Flug, Spilimbergo and Wachtenheim, (1998)).
Next week: Fiscal Policy and the Poor