Fiscal policy in practice
How effective is fiscal policy? The answer depends on the state of the economy, how policy is financed, and how people respond.
Fiscal multipliers
The fiscal multiplier is the change in GDP per dollar of fiscal stimulus. Evidence suggests multipliers are larger in recessions, when resources are idle and central banks keep interest rates low, and smaller near full employment, when extra demand mainly raises prices or interest rates.
Crowding out revisited
If government borrowing raises interest rates, private investment and interest-sensitive spending fall, offsetting some of the stimulus. Crowding out is likely to be small when interest rates are near zero and the central bank is not raising them, and larger when the economy is near capacity.
Ricardian equivalence
Ricardian equivalence, associated with Robert Barro, argues that if people expect a tax cut financed by borrowing to mean higher future taxes, they will save the tax cut, leaving demand unchanged. Evidence suggests this is only partly true: many households spend some of a tax cut, especially those with little savings.
Austerity debates
After the 2008 crisis, several European governments cut spending and raised taxes to reduce deficits (austerity). Critics argued this deepened recessions because multipliers were large; supporters argued it restored confidence and avoided debt crises. Research by the IMF in 2013 suggested multipliers had been underestimated at the time.
Supply-side fiscal policy
Some fiscal policies aim to raise long-run potential output rather than short-run demand: lower marginal tax rates to encourage work and investment, spending on education and infrastructure, and research incentives. Economists debate how large these supply-side effects are; very large claims for tax cuts paying for themselves are generally not supported by evidence.
Fiscal rules
Many countries set fiscal rules, such as limits on deficits or debt. The EU's Stability and Growth Pact set reference values of 3% of GDP for deficits and 60% for debt. Rules aim to prevent excessive borrowing but can force spending cuts in recessions if they are too rigid, so many include escape clauses.
Coordination with monetary policy
Fiscal and monetary policy interact. In the pandemic, governments spent heavily while central banks kept rates near zero and bought government bonds, giving a strong combined stimulus. When both push in the same direction, effects are larger; when they conflict, they can partly cancel out.
Worked example
A government spends an extra 50 billion dollars during a deep recession with interest rates near zero. With a multiplier of 1.5, GDP rises by about 75 billion. The same spending near full employment, with the central bank raising rates to fight inflation, might have a multiplier of 0.5, raising GDP by only 25 billion.
Key takeaways
Fiscal multipliers are larger in recessions and smaller near full employment. Crowding out depends on interest rates and central bank responses. Ricardian equivalence holds only partly. Austerity's effects depend on multipliers, which may have been underestimated after 2008. Supply-side policies target long-run output. Fiscal rules limit borrowing but need flexibility. Fiscal and monetary policy work best in coordination.
Flashcard
Change in GDP per dollar of stimulus
Check your understanding
Why are fiscal multipliers believed to be larger during deep recessions?