Economics Online Tutor
The Effectiveness of Discretionary
Fiscal Policy in Determining the
Level of Real Output
Government purchases financed by printing money

Financing government expenditures with new money involves monetary
Monetary policy is discussed in the next section.
Crowding out:

A reduction in
consumption or
spending caused by
an increase in
Government borrowing can also reduce aggregate demand due to crowding out
of private investment.  A sale of government bonds is often large enough to
influence the market price in the overall bond market.  A large increase in the
supply of bonds will decrease the prices of all bonds in the market.  Lower bond
prices mean higher interest rates.  An increase in interest rates will increase the
cost of borrowing for private firms.  Since most private investment is financed
with borrowed funds, an increase in interest rates will increase the cost of
investment spending and reduce the profitability of investment projects.  This will
reduce the amount of private investment spending, and aggregate demand.

The evidence for the crowding out effect is inconclusive.  Considerable
disagreements exist among economists regarding its importance.
Discretionary fiscal policy can influence the level of aggregate demand,
and real output, both directly and indirectly.  The effectiveness of fiscal
policy in achieving policy goals depends on a number of factors:

The slope of the aggregate supply curve:

John Maynard Keynes developed this model by holding the price level
constant.  In effect, he assumed an aggregate supply curve that is a
horizontal line set at a given price level.  The level of real GDP, then,
would depend entirely on aggregate demand.

This assumption is not entirely unrealistic for what Keynes was trying to
show.  Keynes was dealing with the Great Depression.  He was trying to
show why the self-correcting mechanism of classical economic theory did
not kick in to fix the economy.  Classical economic theory could not
explain the magnitude or the length of the Great Depression.  Keynes
developed a theory to both explain why the classical theory did not work,
and to show how fiscal policy could work to end the Great Depression.

Holding the price level constant emphasized the relationship between
aggregate demand and real output.  Keynes' theory emphasized that
wages and prices are not free to adjust downward.  In his model, during
recessionary times wages and prices will not adjust upward either.
Evidence seems to suggest that when real GDP is well below potential GDP, an increase in aggregate
demand will have little effect on the price level.  This means that the aggregate supply curve is mostly flat
(horizontal) in recessionary times.  But as output increases, the aggregate supply curve steepens.  An
increase in government spending to stimulate aggregate demand will be more effective in increasing real
GDP during a recession but more inflationary as real GDP nears potential GDP.  This can be explained, at
least in part, by the fact that more excess capacity exists during a recession.  When many unemployed
workers are available, and equipment and land sit idle, then output can be increased without putting
upward pressure on prices in the factor markets.  But when excess capacity is not available, then output
can only be increased by bidding up prices in the factor markets.

The multiplier effect:

Government spending is an autonomous portion of aggregate demand.  It's effect on the economy,
however, may be more than the original amount of government spending.  This is because government
purchases become income for somebody in the economy
(the circular flow model); a portion of this
income will be spent, creating income for somebody else; and this process continues to multiply
throughout the economy.
Consumers have two choices
when it comes to disposable
income: they can either spend it
or they can save it.  The portion
that they spend goes directly into
consumption spending,
increasing aggregate demand
and GDP, as well as keeping the
money in the circular flow.  The
portion that they save becomes a
leakage in the circular flow.  It is
not subject to the multiplier
effect.  When disposable income
increases, the portion that is
spent is called the marginal
propensity to consume (MPC).  
The portion that is saved is
called the marginal propensity to
save (MPS).  Both are measured
as a fraction of disposable
income, so that MPC plus MPS
equals one.  Since these are
marginal measurements, they can
change as the level of income
How much is the multiplier effect?  This can be shown with a
simple mathematical formula.

Recall that in the circular flow model, leakages and injections exist.  
Leakages are savings, taxes, and imports.  Injections are
investments, government purchases, and exports.  In equilibrium,
total leakages equal total injections.  Since taxes are used to finance
government spending, they will have their own offsetting multiplier
effect.  The rest of the leakages and injections are incorporated into
the formula:

spending multiplier = 1 / leakages = 1 / (MPS + MPI)

where MPS is the fraction of new income that will be saved instead of
being spent, and MPI is the fraction of new income that will be spent
on imports, or goods that are not produced domestically.

The amount that government spending would have to increase in
order to close a GDP gap is called a recessionary gap.

A recessionary gap is equal to the GDP gap divided
by the spending multiplier.
Methods of financing government purchases

Governments have three methods of raising funds to pay for purchases: taxing, borrowing, and printing

Government purchases financed by taxing

An increase in taxes decreases disposable income, which decreases consumption spending.  This is a
decrease in aggregate demand that will offset the increase in aggregate demand created by an increase
in government spending, but only partially.

The reason that the increase in aggregate demand caused by government spending is greater than the
decrease in aggregate demand caused by taxes is that not all taxes will be paid for with a decrease in
consumption.  A portion of an increase in taxes will be paid for with a decrease in savings.  The net
effect is that aggregate demand will increase by the marginal propensity to save (MPS).

An increase in taxes may also decrease aggregate supply.  With a smaller disposable income, the
incentive to work will be lower.  The opportunity cost of time away from work will decrease.

If an increase in taxes causes the amount of labor input to decrease, then a decrease in aggregate
supply will result.  This will offset, at least partially, any gains in real GDP caused by an increase in
government spending.

This will also create inflation, based on the slopes of the aggregate supply and aggregate demand
curves.  The magnitude of the effect that an increase in taxes has on aggregate supply is open to
debate.  Supply-side economists believe that this effect is very significant.  Keynesian economists
believe that it is insignificant.

Government purchases financed by borrowing

Governments borrow money by selling government bonds in the open market.  To the purchasers of the
bonds, this represents a financial investment.  To the government that issues the bonds, this represents
a loan that has to be repaid.  Each bond has specified dates in which the government must make interest
and principle payments to the investor.  When these payments come due, the government can choose to
finance the payments by issuing new bonds.  Of course, this would be additional deficit spending that
increases the national debt.

Eventually, the money that the government borrows must be paid for with tax collections.  A few
economists believe that consumers will take these future tax payments into consideration when making
spending decisions.  They will reduce consumption, and put money into savings in order to pay for a
future tax increase that has yet to be announced.

This concept is called the Ricardian Equivalence.  The effect of borrowing on aggregate demand would
be the same as the effect of a tax increase.  Most economists do not believe that the Ricardian
Equivalence holds true.
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