Macroeconomics — Fiscal and Monetary Multipliers and Crowding Out

Macroeconomics — The Effect of Fiscal Policy Depends on How the Central Bank Responds

The multiplier of Chapter 14 was an upper bound for the case of a fixed interest rate. In practice, the biggest variable determining the effect of a fiscal expansion is the central bank’s response. This chapter uses the IS-LM economy of Chapter 4 unchanged and computes how different the results of the same fiscal expansion are depending on the monetary response.

1. Three central bank responses

In the Chapter 4 economy the initial equilibrium is $Y=400$ and $r=1\%$; IS is $Y=410-10r$, money demand is $0.5Y-20r$ and real balances are 180. If government spending rises by 10 trillion won, IS shifts to $Y=460-10r$.

To hold the rate at 1%, the central bank must increase real balances. At $Y=450$ and $r=1$, money demand is $0.5\times 450-20=205$, so real balances rise by 25, from 180 to 205. Monetary policy has supported the fiscal expansion. Conversely, if the central bank raises rates further for fear of overheating, crowding out grows.

2. The open economy: crowding out through the exchange rate

In a floating-rate economy with free capital mobility, if fiscal expansion raises the domestic interest rate, foreign capital flows in and the currency appreciates. Appreciation cuts exports and raises imports. Net exports fall until the domestic rate returns to the world rate; in the extreme, the whole effect of the fiscal expansion is offset by lower net exports. Monetary expansion, by contrast, lowers the rate, depreciates the currency and raises net exports, so its effect grows. These conclusions of the Mundell-Fleming model, and the opposite results under fixed exchange rates, are covered in International Finance Chapter 3.

3. Ricardian equivalence

If spending is financed with government bonds, households may anticipate future taxes and save more. If full Ricardian equivalence holds, a tax cut has no effect. Government spending itself, however, raises demand even under equivalence, because the government uses resources directly. The conditions under which equivalence breaks down (liquidity constraints, finite lives, distortionary taxes) were covered in Public Finance Chapter 6.

4. The policy mix and fiscal dominance

If monetary policy always accommodates fiscal policy, the central bank ends up financing government deficits with money (fiscal dominance). When people anticipate this, expected inflation rises and the credibility of the inflation target collapses. Central bank independence and limits on the direct purchase of government bonds with newly issued money are the institutions that guard against this risk.

Check your understanding

In the economy above, what is the new equilibrium if government spending rises by 20 trillion won and the money supply is fixed? IS is $Y=510-10r$ and LM is $r=0.025Y-9$, so $Y=510-0.25Y+90$ gives $Y=480$ and $r=3\%$. Output rises by 80 trillion won, 20 trillion less than with a fixed rate (100 trillion). To hold the rate at 1%, the central bank would have to raise real balances by 50, to $0.5\times 500-20=230$.

References

• N. Gregory Mankiw, Macroeconomics, ch. 12–13
• Robert Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science (1963)
• Thomas Sargent and Neil Wallace, “Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank of Minneapolis Quarterly Review (1981)