Q: Consider the following statement. "Fiscal policy is a very precise tool for controlling aggregate demand. If the government wants to increase aggregate demand by $5 billion, all it has to do is carry out exactly $5 billion worth of government spending." Is this statement true or false? Explain. In your answer, consider both a closed economy and an open economy. Also, consider the difference between fixed and floating exchange rates in the open economy.

CJB: Fiscal policy is, at best, an imprecise tool for controlling aggregate demand. The statement implies a 1-to-1 correlation between a dollar’s worth of government spending and a corresponding increase in aggregate demand. But a dollar of government spending could generate more or less than a dollar’s increase in aggregate demand. It could also fail to have any effect on aggregate demand whatsoever. Government spending’s ultimate affect on aggregate demand depends on the interaction of several key variables: whether an economy is open or closed; and whether that economy’s exchange rate is fixed or flexible.

In a closed economy, a $5 billion increase in government spending will initially increase aggregate demand by $5 billion. The multiplier effect – the additional shifts in demand that occur when expansionary fiscal policy increases income and consumer spending – will then generate an additional shift in aggregate demand. For example, suppose that the closed economy’s marginal propensity to consume (MPC) is .85; that is, for every dollar that a household in the economy earns, it spends $.85 and saves $.15. The multiplier is then given by the formula 1/ (1-.85), or 6.666. In this economy, $5 billion of government spending would generate $33.3 billion of aggregate demand. However, the increase in income would also raise the demand for money in the economy, as households seeking to consume additional goods and services would choose to hold more of their wealth in liquid form. Because the supply of money in the economy is fixed, interest rates would increase to bring the demand for money and the supply of money back into equilibrium. The increase in interest rates would create a corresponding drop in the demand for investment goods. In other words, the increase in government spending would crowd out investment, which would cause the aggregate demand curve to drop back from the $33.3 billion of “additional” aggregate demand. In a closed economy with a high MPC, $5 billion of spending would probably generate more than a $5 billion increase in aggregate demand; the increase in demand would outweigh the crowding-out effect. But in a closed economy with a low MPC, it is equally likely that the crowding-out effect would outweigh the multiplier effect and shift aggregate demand by less than $5 billion.

A similar situation would prevail in an open economy with a flexible exchange rate, with a few additional wrinkles. First, given perfect capital mobility, and ignoring tax and default risk, the open economy’s initial interest rate before the $5 billion of additional government spending would equal the world interest rate, R(w). As before, the rise in household income created by the multiplier effect and the corresponding increased demand for liquid wealth would cause the interest rate to rise until the local interest rate, R(loc), > R(w). The interest rate increase would have two effects. First, as before, it would crowd out investment spending and decrease aggregate demand. The higher local interest rate would also generate additional foreign demand for local assets. This demand would generate additional demand for dollars in the foreign currency exchange market, which would cause the dollar to appreciate and net exports to decrease. The fall in net exports would generate a reduction in consumer spending, a corresponding reduction in money demand, and a reduction in interest rates until R(loc) once again = R(w). Consequently, the government spending increase would have no lasting impact on aggregate demand.

A slightly different situation would prevail in an open economy with a fixed exchange rate. As in an open economy with a flexible exchange rate, $5 billion of government spending would increase aggregate demand, increase demand for liquid wealth, and raise interest rates until R(loc) > R(w). As before, a local interest rate above R(w) would generate additional world demand for local assets, and the dollar would appreciate. To prevent the value of the dollar from floating, the government would increase the supply of dollars available by purchasing foreign currency in exchange for dollars, which would cause the interest rate to fall until R(loc) once again = R(w). The non-appreciation of the dollar would prevent net exports from decreasing as they would in an open economy with a floating exchange rate. The money supply increase, coupled with the $5 billion spending increase, would shift the aggregate demand curve even further than it would in a closed economy, and generate a substantial increase in demand for goods and services.
- posted by cjb @ 10:36 PM