How does a fiscal boost work?

This is an important question, given that we are in a situation where governments around the world are looking to loosen fiscal policy. Tyler Cowen succinctly lists the four (five) ways that fiscal policy influences the economic situation – note that this ignores issues of the quality or distribution of spending. These are:

1. Generate some investments which are worthwhile on their own terms,
2. If the broader monetary aggregates are falling, because of either a credit crunch or a liquidity trap, a fiscal boost can keep aggregate demand from deteriorating,
3. fiscal boost can provide a beneficial “sunspot” in a multiple equilibrium model, thereby moving everyone to the higher output equilibrium,
4. If spending needs to fall, a fiscal boost can postpone this fall,
5. The economy needs a boost to aggregate demand and since monetary policy isn’t working any more, fiscal policy has to step in (which he notes requires 2 and 4 anyway).

So what do I have to add – only a little bit.

Sunspots

I feel that the concept of “sunspots” is abused by people who want to say that the government is the only body that can save the economy. Ultimately, we need to ask – what is causing the existence of “multiple equilibrium” in the economy, and in what ways can government help. This is a better technique than simply stating that there is a sunspot equilibrium and starting the spending spree!

Sunspot equilibrium rely on the idea that individuals actions are “strategic complements” in some sense.

Wikipedia nicely informs us of the following:

Proper sunspot equilibria can exist in a number of economic situations, including asymmetric information, externalities in consumption or production, imperfect competition, incomplete markets, and restrictions on market participation

Now these are all market failures aren’t they. These are specific issues that the government may want to intervene in – however, they don’t give credence to the idea that “expansionary fiscal policy” is the way to save the day.

The idea of a sunspot equilibrium also captures the idea of “expectations” – in the short-term we may face a sharp decline in expectations of growth (for no real reason other than blanket pessimism), even though fundamentals are unchanged. This change in expectations MAY be reinforcing and lead us to a lower equilibrium. If the government can prop up growth, or act in a way to change expectations, then we can prevent this decline from fundamentals.

In this case we have two roles that are given to government policy:

1. Solve market failures,
2. Help mediate significant shifts in consumer and business sentiment that are unrelated to fundamentals.

If we believe the government is well placed to do these things (eg have better information about the state of the economy, and can identify and target market failures) – then it should.

However, there is no blanket argument that tells us “sunspots exist – so the government should push us up to higher output equilibrium”. In fact, I think that the conditions are actually restrictive when looking at justifying “additional” government policy – most of the worthwhile solutions for market failures should have occurred during normal economic times.

Price flexibility and the importance of point 2

I would also note that any justification of government intervention depends strongly on the flexibility of prices. If prices in the economy cannot change, then the entire adjustment process occurs through economic activity. If there is a decrease in productivity in one industry, the inability for prices to adjust leads to a sharper reduction in activity in this industry causing an excess supply of labour. Other industries haven’t experienced anything and so do not change – leading to higher unemployment and a larger fall in labour market income. Which in turn leads to a larger reduction in activity in many industries than would be expected if prices were flexible.

Government policy is useful if nominal prices in some areas cannot fall – effectively they can devalue the currency in order to reduce the real prices of these goods, and improve the allocation of resources. If the allocation of resources improves, then we effectively have a higher national income, and so the loss associated with any adjustment in the economy is less severe.