Select the correct answer from each drop-down menu how did the government help the economy

Heat pipe tunnel

History, instability, and growthPolitics and policy

How governments can moderate costly fluctuations in employment and income

• Fluctuations in aggregate demand affect GDP growth through a multiplier process, because households face limits to their ability to save, borrow, and share risks.
• An increase in the size of government following the Second World War coincided with smaller economic fluctuations.
• Governments can use changes in taxes or government spending to stabilize the economy, but bad policy can destabilize it.
• If a single household saves, its wealth necessarily increases, but if all households save this may not be true, because without additional spending by the government or firms to counteract the fall in demand, aggregate income will fall.
• Every national economy is embedded in the world economy. This is a source of shocks, both good and bad, and places constraints on the kinds of policies that can be effective.

In August 1960, three months before he was elected US president, the 43-year-old Senator John F. Kennedy found time to spend the day cruising Nantucket Sound on his boat, the Marlin. His crew for the day included John Kenneth Galbraith and Seymour Harris, both Harvard economists, and Paul Samuelson, an economist at MIT and later also a Nobel laureate. They had not been recruited for their nautical skills. In fact, apart from Harris, the senator did not even know them.

The future president wanted to learn ‘the new economics’, which John Maynard Keynes, an economist who we will learn more about in Section 14.6, had formulated in response to the Great Depression. When Kennedy was a teenager in the decade before the Second World War, the US and many other countries experienced a drastic fall in output (we can see this for the US in Figure 14.1) and massive unemployment that persisted for more than 10 years.

Kennedy had a lot to learn. He admitted that he had barely passed the only economics course he took at Harvard. He would later spend a day at the America’s Cup sailing races being tutored by Harris, who assigned texts for him to read. Harris later gave private lessons to the senator, shuttling by air between Boston, where he worked, and Washington DC.

In 1948, Samuelson had written Economics, the first major textbook to teach these new ideas. Harris promoted the same economic ideas in a book that he edited in 1948 called Saving American Capitalism, a collection of 31 essays by 24 contributors. At that time, it seemed that capitalism needed saving: the centrally planned economies of the Soviet Union and its allies, a model promoted as the alternative to capitalism, had entirely avoided the Great Depression. Kennedy needed economics to understand policies that could promote economic growth, reduce unemployment, but also avoid economic instability.

We have seen in Unit 13 that instability in the economy as a whole is characteristic not only of economies dominated by agriculture, but also of capitalist economies. Figure 14.1 shows the annual growth of real GDP in the US economy since 1870.

Keynes was born into an academic family in Cambridge, UK. He studied mathematics at King’s College, Cambridge and then became an economist and prominent follower of the renowned Cambridge professor, Alfred Marshall. Before the First World War, Keynes was a world authority on the quantity theory of money and the gold standard, and held conservative views on economic policy, arguing for a limited role of government. But his views would soon change.

In 1919, following the end of the First World War, Keynes published The Economic Consequences of the Peace, which opposed the Versailles settlement that ended the war.2 This book instantly made him a global celebrity. Keynes rightly argued that Germany could not pay large reparations for the war, and that an attempt to make Germany do this would help provoke a worldwide economic crisis. In 1925, Keynes opposed Britain’s return to the gold standard, arguing that this policy would lead to a contraction of the economy. In 1929 there was a financial crash and global crisis. The Great Depression followed. In 1931 Britain was driven off the gold standard.

In response to these dramatic events, Keynes explained that the orthodox monetary policies required by the gold standard would worsen the depression, and that the world needed policies to increase aggregate demand. In 1936, he published The General Theory of Employment, Interest and Money in which he set out an economic model to explain these views.3 The General Theory immediately became world famous, particularly for the idea of the multiplier, which is explained in this unit. In The General Theory, Keynes reasoned that if interest rates were already very low, then fiscal expansion would be necessary to alleviate depression. Such was the lasting influence of his work that the initial response in many countries to the global economic crisis of 2008 was to apply such Keynesian policies.

During the Second World War, Keynes turned to postwar reconstruction, determined to ensure that the mistakes that followed the First World War would not be repeated. In 1944, with Harry Dexter White of the US, he led an international conference at Bretton Woods in New Hampshire that resulted in the creation of a new international monetary system, managed by the International Monetary Fund, or IMF. The Bretton Woods system was designed to avoid the mistakes Keynes had unsuccessfully warned against in the aftermath of the First World War, and to ensure that a country that was in recession (and had balance of payments difficulties) would not need to follow the contractionary policies required by the gold standard. A country like this could use fiscal policy to pursue full employment, while at the same time it could devalue its exchange rate to encourage exports, reduce imports, and achieve a satisfactory balance of payments position.

Keynes led a remarkably varied life. He was an academic, a senior civil servant, owner of the New Statesman magazine, financial speculator, chairman of an insurance company, and member of the British House of Lords. He was also the founder of the Arts Council of Great Britain and chairman of the Covent Garden Opera Company. He was married to the Russian ballerina Lydia Lopokova and was a key member of the Bloomsbury Group, a remarkable circle of artistic and literary friends in London, which included the novelist Virginia Woolf.

In 1926, in a pamphlet entitled The End of Laissez-Faire,4 he wrote:

For my part I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways extremely objectionable. Our problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life.

How governments can amplify fluctuations

Keynes’ argument refers to the cell in the bottom right of Figure 14.12 at the end of this section: poor policymaking that amplifies the business cycle.

Sometimes a government chooses to raise taxes or cut spending during a recession because it is concerned about the effect of a recession on its budget balance. The government budget balance is the difference between government revenue less transfers, T, and government spending, G, that is, (T − G). As we have seen, if the economy is in recession, government transfers, like unemployment benefits, rise while tax revenues fall, so the government’s budget balance deteriorates and may become negative.

When the government’s budget balance is negative, this is called a government budget deficit—government spending on goods and services, including investment spending, plus spending on transfers (such as pensions and unemployment benefits) is greater than government tax revenue. A government budget surplus is when tax revenue is greater than government spending. To summarize:

• Budget in balance: G = T
• Budget deficit: G > T
• Budget surplus: G < T

The worsening of the government’s budgetary position in a recession is part of its stabilizing role. Conversely, when the government chooses to override the stabilizers to reduce its deficit, this may amplify fluctuations in the economy.

Suppose a government tries to improve its budgetary position in a recession by cutting its spending. This, like a tax increase, is referred to as austerity policy. Follow the analysis in Figure 14.11b to see how austerity policy can reinforce a recession by further reducing aggregate demand.

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Goods market equilibrium

The economy starts at point A in goods market equilibrium, at which aggregate demand is equal to output.

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The economy moves into recession

This occurs after a fall in consumer confidence, reducing c0. The aggregate demand line shifts downward and the economy moves from point A to point B.

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Austerity policy

Suppose that the government then reduces spending from G to G′, in a bid to offset the deterioration of its budget balance. The recession then feeds back to raise government transfers and reduce tax revenue.

Does this argument mean that governments should never impose austerity in order to reduce a fiscal deficit? No—just that a recession is not a wise time to do it. Running government deficits under the wrong economic conditions can be harmful. In a well-designed policy framework, there will be constraints on government action, as we will see in Section 14.8.

The table in Figure 14.12 summarizes the lessons so far. The first row gives examples of how household behaviour may either smooth or disrupt the economy. The terms negative and positive feedback are used to refer to dampening and amplifying mechanisms in the business cycle.

Figure 14.12 The role of the private sector and the government in the business cycle.

Assume the government is initially in budget balance.

1. Does the government’s budget balance improve, deteriorate, or remain unchanged if the government cuts its spending in a recession, ceteris paribus? To answer this question, use the example in Figure 14.11b. Assume the budget was in balance at point A. Once at B, the government cuts G in an attempt to improve its budget balance. Assume there are no unemployment benefits and a linear tax.
2. Evaluate the government’s policy.

Which of the following statements is correct?

• Maintaining fiscal balance in a recession helps to stabilize the economy.
• Automatic stabilizers refer to the fact that economic shocks are partly offset by households smoothing their consumption in the face of variable income.
• The multiplier on a fiscal stimulus is higher when the economy is functioning at full capacity.
• A fiscal stimulus can be implemented by raising spending to directly increase demand, or by cutting taxes to increase private sector demand.

• If the government maintains fiscal balance then it is not offsetting the decline in private demand.
• Automatic stabilizers refer to government policies that smooth household disposable incomes, such as taxes and unemployment benefits.
• The multiplier as we have defined it so far assumes that there is spare capacity in the economy. It will be low or zero if there is little or no spare capacity.
• A rise in G increases aggregate demand directly while a cut in taxes can increase C and/or I, representing increased private sector demand.

14.7 The multiplier and economic policymaking

In the multiplier model, we have used simple ways of modelling aggregate consumption, investment, trade, and government fiscal policy. This means there are a small number of variables from which the size of the multiplier is calculated (the marginal propensity to consume, the marginal propensity to import, and the tax rate). When we apply the model to the real world, it is important to realize that there is no single multiplier that applies at all times.

The effect of an increase in government spending in reducing private spending, as would be expected for example in an economy working at full capacity utilization, or when a fiscal expansion is associated with a rise in the interest rate.

The multiplier will be a different size if the economy is operating at full capacity utilization and low unemployment than in a recession. With fully employed resources, a 1% increase in government spending would displace or crowd out some private spending in the economy. To consider an extreme case, if all workers are employed, then an increase in government employment can only come about by taking workers out of the private sector. If increased government production were offset exactly by reduced private sector production, then the multiplier would be zero.

We would not normally expect a government to undertake a fiscal expansion when unemployment is very low—although it may in exceptional circumstances like war, as the US did in the later years of the Second World War and in the Vietnam War.

The size of the multiplier will also depend on the expectations of firms and businesses. The economy is not like a bicycle tyre, from which air can be pumped in or let out to keep the pressure at the right level. Households and firms react to policy changes, but they also anticipate them. For example, if firms anticipate that the government will stabilize the economy following a negative shock, this will support business confidence, and the policymaker will be able to use a smaller stimulus. Alternatively, if households think that higher government spending will be followed by higher taxes, those who have the ability to save may put aside more of their money to pay the extra taxes. If this happened, it would reduce the impact of the stimulus.

When the financial crisis in 2008 led to the biggest fall in GDP in many economies since the Great Depression, the world’s policymakers expected an answer from economists: would fiscal policy help to stabilize the economy? The multiplier model, inspired by Keynes’ analysis of the Great Depression, suggested that it would. But by 2008, many economists doubted that the Keynesian model was still relevant. The crisis has revived interest in it and has led to a greater, though not complete, consensus among economists about the size of the multiplier (see below).

In 2012 a study published by Alan Auerbach and Yuriy Gorodnichenko, two economists, showed how the multiplier varies in size according to whether the economy is in a recession or in an expansion.5 This is exactly the insight that policymakers needed in 2008.

For the US, their study suggested a $1 increase in government spending in the US raises output by about $1.50 to $2.00 in a recession, but only about $0.50 in an expansion. Auerbach and Gorodnichenko extended their research to other countries and found similar results. They also found that the effect of autonomous increases in spending in one country had spillover effects on the countries with which they trade. These effects were about the same magnitude as the indirect effects of second, third, and further rounds of spending in the home country.

natural experimentAn empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.reverse causalityA two-way causal relationship in which A affects B and B also affects A.

It may surprise you that economists have used the Italian government’s struggle against the Mafia to uncover the size of the multiplier, but that’s what Antonio Acconcia, Giancarlo Corsetti, and Saverio Simonelli were able to do.6 Adopting the natural experiment method to address the problem of reverse causality, they used data on Mafia-related dismissals of local politicians to isolate the variation in public spending that is not caused by variations in output.

After legal changes in 1991, the central government dismissed provincial councils in Italy who were revealed to have close links with the Mafia, and appointed new officials in their place. These technocrats cut local spending by 20% on average. The change in public spending occurred because of the Mafia links, through their effect on the replacement of government officials. And because there is no direct causal link from proximity to the Mafia to the variation in output, proximity to the Mafia can be used to uncover the causal effect of a change in public spending on output. This situation is illustrated in Figure 14.13.

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Figure 14.13 Using Mafia proximity to estimate the multiplier.

Using this method, the researchers were able to estimate multipliers of 1.5 at the local level.

Economists have used their ingenuity to come up with methods of estimating the size of the multiplier and the implication of its operation for jobs. Using the US stimulus program that was implemented in the wake of the financial crisis (the American Recovery and Reinvestment Act of 2009, a $787 billion fiscal stimulus), we would expect that US states that were more severely hit by the financial crisis would have had higher unemployment and attracted more stimulus spending by the government. So unemployment causes more spending in those states. This makes it difficult to estimate the effect of higher spending on output and unemployment, which is what we want to do if we want to know the size of the multiplier.

One approach to get around this problem of reverse causality is to make use of the fact that some of the spending in the US stimulus program was distributed to US states using a formula that was unrelated to the severity of the recession experienced in each state. For example, some road-repair expenditures funded by the stimulus package were based on the length of highway in each state.7

Given the formula for allocating road-building funds and the fact that more miles of highway has no direct effect on the change in unemployment, this allows us to answer the question: were more jobs created in states that received more stimulus spending?8

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Figure 14.14 Using US stimulus highway spending to estimate the multiplier.

The results of studies using this approach estimated a multiplier of 2, and suggest that the American Recovery and Reinvestment Act created between 1 million and 3 million new jobs.

In spite of scepticism among some economists before the 2008 crisis that the multiplier was greater than one, policymakers around the world embarked on fiscal stimulus programs in 2008–09. Fiscal stimulus was credited with helping to avert another Great Depression, as we will see in Unit 17.

There are few questions in economic policy discussed as heatedly in the years since the financial crisis in 2008 as the size of the fiscal multiplier: what is the effect on GDP of a 1% increase in government spending?

Much of the heat is generated by political differences among those involved. People who favour greater government expenditure tend to think the multiplier is large, while those who would like a smaller government tend to think that it is small. (We don’t know whether this correlation is because their beliefs about government influence their estimates of the size of the multiplier, or the other way round.)

This debate has been going on since the first theoretical formalization of the multiplier by John Maynard Keynes in the 1930s. The recent economic crisis has revitalized it for two reasons:

1. Monetary policy could not be used: Following the financial crisis, several major economies remained in recession despite central banks cutting interest rates to very close to zero. As we will see in the next unit, interest rates cannot be cut below zero, so governments wanted to know if the fiscal stimulus of an increase in government spending would help stabilize the economy.
2. Arguments about whether austerity works: After the Eurozone crisis in 2010, many European countries that were in recession adopted austerity measures of cutting government spending, with the objective of bringing their public finances back to balance.

In both stimulus and austerity, the success of the policy depends on the size of the multiplier. If the multiplier is negative—which could happen if a rising fiscal deficit causes a large reduction in confidence—a stimulus package would lead to a reduction in GDP, and an austerity policy would cause GDP to rise. If the multiplier is positive but less than 1, a fiscal stimulus would raise GDP but by less than the increase in government spending. If, as in our multiplier model, the multiplier is greater than 1, a fiscal stimulus would raise GDP by more than the increase in government spending and a policy of austerity would reinforce the recession conditions.

Depending on methodologies and assumptions, economists have put forward different estimates of multipliers, from negative numbers to values greater than 2. For instance, members of President Obama’s Council of Economic Advisors estimated the multiplier as 1.6 when they prepared the American Recovery and Reinvestment Act of 2009. The International Monetary Fund presented estimates in 2012 that multipliers in advanced economies were, after the crisis, between 0.9 and 1.7.9

To be effective, government spending needs to put resources that would otherwise be idle into productive use. These resources can be unemployed (or underemployed) workers, as well as offices, shops, or factories functioning with spare capacity. When an economy functions at full capacity (with no idle resources), extra government spending will crowd out private spending.

Robert Barro and Paul Krugman, the economists, disagreed about the size of the multiplier in the weeks that followed the enactment of the American Recovery and Reinvestment Act in early 2009. Using data on government defence spending during the Second World War, Barro concluded that the multiplier was not larger than 0.8. That is, spending $1 on military equipment yielded only 80 cents of output. However, Krugman responded that in wartime there are no idle productive resources to take advantage of. People of working age were in work supporting the war effort in factories, and the government used rationing to depress private consumption.10

In the recessions that followed the Eurozone crisis in 2010, just as new economic research was finding evidence that multipliers in recessions were well above one, many European governments implemented fiscal austerity to balance their budgets. These countries had poor growth outcomes—another sign that, in deep recessions, the multiplier is greater than one. But some Eurozone countries had no choice but to adopt austerity policies. As we will see in the next section, they had lost the ability to borrow.

Consider the three methods discussed in this unit that have been used to estimate the size of the multiplier: the Mafia-related dismissals in Italy, the stimulus highway spending in the US, and wartime defence spending in the US.

Why do you think estimates of the size of the multiplier vary? Use the material in this unit to support your explanation.

In the table in Figure 13.8 we showed the contributions of the main components of expenditure (C, I, G, and X − M) made to US GDP growth during the recession of 2009. We can use FRED to see whether these contributions changed during the recovery phase of the recession.

Go to the FRED website. You can watch this short tutorial to understand how FRED works. Search for ‘Contribution to GDP’ using the search bar, and select this annual series:

• Contributions to percentage change in real gross domestic product: Personal consumption expenditures

Make sure the frequency is quarterly. To change the frequency of your series, click the ‘Edit graph’ button above the top-right corner of the graph.

This button also allows you to add other series to your graph. Click on ‘Add line’ and search for the following series:

• Contributions to percentage change in real gross domestic product: Gross private domestic investment
• Contributions to percentage change in real gross domestic product: Government consumption expenditures and gross investment
• Contributions to percentage change in real gross domestic product: Net exports of goods and services

Finally, add a series for real GDP (‘Real Gross Domestic Product’). Make sure you select quarterly frequency for all series on your graph.

1. Do the contributions to GDP add up approximately to the growth of GDP?

Now use the data you have downloaded to carry out the following tasks for the period from 2007 to 2014:

1. Describe the contributions to US GDP growth in the recession (2008 Q1 to 2009 Q2) and in the recovery phase from 2009 Q3 of the business cycle. If you analyse the data using the FRED graph, you will see the recession shaded in the chart. Prepare a table like the one in Figure 13.8.
2. What might explain the differences seen in the role of consumption and investment during the recession and recovery phases of the business cycle?
3. From the contribution to GDP growth of government consumption and investment expenditure, what can you infer about the US government’s fiscal policy during the crisis?

Note: To make sure you understand how these FRED graphs are created, you may want to extract the data into your spreadsheet and reproduce the series.

In an article from August 2014, ‘The Fall of France’, Paul Krugman criticizes the austerity policy implemented in France.

Use what you have learned about the fiscal multiplier to explain why, in Krugman’s opinion, fiscal austerity in France (and more generally in Europe) would fail (explain carefully what you think Krugman means by ‘fail’).

Read ‘Stimulus, Without More Debt’ by Robert Shiller.

Assume the economy is in a recession. The government has a high level of debt and wants to set a balanced budget, that is, G = T. How can the government achieve a fiscal stimulus effect on GDP whilst keeping the budget balanced?

To answer the question, take the following steps:

• Show how this is possible in a multiplier diagram, ensuring that you label the relevant intercepts and angles. Make the diagram sufficiently accurate so that the exact size of the multiplier is visible.
• Explain in words how the government can achieve such a fiscal stimulus effect whilst keeping the budget balanced.
• Derive the balanced budget multiplier using algebra. (Hint: You will need to write down expressions for the change in GDP associated with a change in both G and T and set these equal to each other.)
• Comment briefly on any disadvantages you see with the use of this balanced budget fiscal stimulus.

You can make the following assumptions:

• Assume a lump sum tax. This means that the tax does not depend on the level of income, T = T, rather than our usual assumption that T = tY.
• Also assume that the country does not have any imports or exports.

Which of the following statements is correct regarding the multiplier?

• Economists tend to agree on their estimates of the multiplier.
• Reverse causation can be a problem when estimating the multiplier empirically.
• If households anticipate that increased government spending will be funded by future tax increases, then the multiplier will be higher.
• If firms anticipate that the government’s fiscal policy will be effective, then the multiplier will be higher.

• Estimates of the multiplier vary widely.
• If more fiscal stimulus is given to economies with higher unemployment then reverse causality can be a problem for estimates of the multiplier.
• In this case, households may increase savings today in order to pay for the anticipated tax increases, reducing their marginal propensity to spend and hence reducing the multiplier.
• Firms will increase investment if they believe the economy will recover quickly, increasing demand.

History, instability, and growthGlobal economyPolitics and policy

14.8 The government’s finances

From the paradox of thrift, we learned that in a recession, it is counterproductive for the government to offset the automatic stabilization of the economy. We have also learned that using a fiscal stimulus to boost aggregate demand in a deep recession can be justified, under conditions in which the multiplier is greater than one. So why are stimulus policies often followed by policies of austerity? The answer is the government’s debt. To understand why, we turn to the government’s revenue and its expenditure.

Revenue

Governments raise revenue in the form of income taxes and taxes on spending, often called Value Added Tax (VAT) or sales tax. They also raise money from a variety of other sources including taxes on products like alcohol, tobacco, and petrol—and on wealth, including through inheritance taxes.

Expenditure

Government expenditure includes health, education, and defence, as well as public investment such as roads and schools.

Government revenue is also used to fund social security transfers, which include unemployment benefits, pensions, and disability benefits. The government also has to pay interest on its debt. Transfers and interest payments are paid out of government revenues, but they do not count in G because the government is not spending money on goods or services.

Government primary deficit

The government deficit, excluding interest payments on its debt, is called the primary budget deficit and is measured by G − T, where T is tax revenue minus transfers (assumed to be tY in the multiplier model with a proportional tax rate, t). If the initial situation is one of a zero primary deficit, then it automatically worsens in a business cycle downturn. When the downturn reverses, the government’s primary budget deficit will decline, and in the upswing, the government will have higher revenues than spending.

When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure. The government borrows by selling bonds. Firms and households buy the bonds. Households usually buy them indirectly, because they are bought by pension funds, from which households buy pensions. The sale of bonds adds to the government’s debt.

Because of the existence of global financial markets, foreigners can also buy home country bonds. Government bonds are attractive to investors because they pay a fixed interest rate and because they are generally considered a safe investment: the default risk on government bonds is usually low. Investors are likely to want to hold a mixture of safe and risky assets, and government bonds are normally at the safe end of the spectrum.

A sovereign debt crisis is a situation in which government bonds come to be considered risky. Such crises are not uncommon in developing and emerging economies, but they are rare in advanced economies. However, in 2010, there was an increase in interest rates on bonds issued by the Irish, Greek, Spanish, and Portuguese governments, which was a signal of a sharp increase in default risk—the likelihood that the government would be unable to make the required payments on its debt. It marked the start of the Eurozone crisis. Governments of countries experiencing a sovereign debt crisis may have no alternative to austerity policies if they can no longer borrow, because in this case they cannot spend more than the tax revenue they receive.

A large stock of debt relative to GDP can be a problem because, like a household, the government has to pay interest on its debt and it has to raise revenue to pay the interest, which may require raising tax rates. However, governments are not like households in that there is no point at which they need to have paid off all their stock of debt—as one set of bonds matures, governments will typically issue more bonds, maintaining a stock of debt (this is called rolling over debt, which firms also typically do to finance their operations). Indeed, because government bonds are generally seen as a safe asset outside periods of crisis, there is usually demand for government debt from private investors. As the long-run data for the UK in Figure 14.15 makes clear, there are no general rules about how much debt is safe for governments to have.

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Figure 14.15 UK government debt as a percentage of GDP (1700–2020).

Figure 14.15 shows the path of UK government debt from 1700 to 2020. The level of indebtedness of a government is measured in relation to the size of the economy, that is, as a percentage of GDP. The two big upward spikes in the British debt to GDP ratio in the twentieth century were caused by the need for the government to borrow to finance the war effort.

Financial crises also raise government debt. Governments borrow both to bail out failing banks and to support the economy in the lengthy recessions that follow financial crises. The UK’s debt-to-GDP ratio rapidly doubled to more than 80% after the 2008 global financial crisis and surpassed 100% in response to the COVID-19 pandemic.

Note also that, although the UK government emerged from the Second World War with a very high level of debt, it fell rapidly in the following decades: from 260% of GDP to 50% by the 1980s. Why? The British government ran a primary budget surplus in every year except one from 1948 until 1973, which helped to reduce the debt-to-GDP ratio. But the ratio may also fall even when there is a primary budget deficit, as long as the growth rate of the economy is higher than the interest rate. During the period of rapid reduction of the British debt ratio, in addition to the primary surpluses, there was moderate growth, low nominal interest rates set by the government, and moderate inflation.

Why does inflation help a country reduce its debt ratio? Because the face value of government bonds (the level of debt) is denominated in nominal terms. For instance, the issue of 10-year bonds in 1950 would promise to repay £1 million in 1960. So if inflation was moderately high during the 1950s, then nominal GDP would be growing fast while that £1 million owed in 1960 would remain constant, meaning the debt would have shrunk relative to GDP. As we discuss further in Unit 15, inflation reduces the real value of debt.

For many advanced economies, there have been extended periods in which the growth rate has been higher than the interest rate. Brad DeLong, an economist, has pointed out that this has been true for the US for almost all of the last 125 years.11

How would you use the criteria of Pareto improvement and fairness to evaluate the use of stimulus policies and bank bailouts following the global financial crisis of 2007–2008?

Hint: you might want to look back at Sections 5.2 and 5.3 in Unit 5, where the concepts are explained.

Countries with aging populations have demographic trends that imply upward pressure on the debt-to-GDP ratio, because the proportion of government revenue spent on state pensions, healthcare, and social care for the elderly will increase. Many governments and voters are facing a difficult choice: do they limit benefits, or put up taxes?12

The lessons from our discussion of fiscal policy and government debt are:

• Automatic stabilizers play a useful role: Over the course of the business cycle, they contribute to economic wellbeing.
• If additional fiscal stimulus is used, this ought to be reversed later: This reversal can take place when the economy is growing again. If a stimulus is not reversed, the government debt-to-GDP ratio will rise.
• Financial crises and wars increase government debt.
• Inflation reduces the debt burden of the government: Likewise, deflation increases it.
• An ever-increasing debt ratio is unsustainable: But there is no rule that says exactly how much debt is problematic.
• If the growth rate is below the interest rate, it is necessary to run primary government surpluses as they stabilize and reduce the debt ratio: Attempting to reduce the debt ratio rapidly, however, is counterproductive if it depresses growth.

To get a feel for the effects of policy interventions, The Economist provides a modelling tool to experiment as a hypothetical policymaker. Try different combinations of primary budget balance, growth rate, nominal interest rate, and inflation rate as methods of preventing the debt ratio from continuously rising in a country of your choice.

Global economyPolitics and policy

14.9 Fiscal policy and the rest of the world

In Unit 13 we saw that agrarian economies suffered shocks from wars, disease, and the weather. In Unit 11, we saw that the American Civil War affected economies including Brazil, India and the UK. In modern economies, what happens in the rest of the world is a source of shocks, and also affects how domestic economic policy works. To avoid making mistakes, policymakers need to know about these interactions.

Foreign markets matter

Fluctuations in growth in important markets abroad can explain why the economy moves into an upswing or downswing: this is a change in the net export component of aggregate demand, that is, (X − M). China, for example, is a very important market for Australian exports (32% of Australian exports went to China in 2013, accounting for 6.5% of Australian aggregate demand). When the Chinese economy slowed down from a growth rate of 10.6% in 2010 to 7.8% in 2013, this was transmitted directly to a slowdown in growth in Australia via a fall in net exports.

Similarly, the slowdown in the Eurozone because of the 2010 crisis that followed the 2008 global financial crisis, was an important reason for the slug­gishness of the British economy’s exit from recession. This is because a high proportion of UK exports go to the EU. For example, 44% of the UK’s exports went to the EU in 2013, accounting for 13% of UK aggregate demand.

Imports dampen domestic fluctuations

As we have seen, the size of the multiplier is reduced by the marginal propensity to import. When autonomous demand goes up, it stimulates spending, and some of the products bought are produced abroad. This dampens the domestic upswing.

Trade constrains the use of fiscal stimulus

Trade with other countries constrains the ability of domestic fiscal policymakers to use stimulus policies in a recession. A striking example comes from France in the 1980s. At the start of the 1980s, the French economy remained weak following the oil shocks of the 1970s, which disrupted the world economy. In 1981, the socialist candidate François Mitterrand won the presidential election. His appointed prime minister, Pierre Mauroy, implemented a program to stimulate aggregate demand through increased government spending and tax cuts (in the multiplier model, this is a rise in G and a fall in t, the tax rate).

In Figure 14.16, we show what happened in France and in its biggest trading partner, Germany. The purple bars show the outcomes for France and the orange bars show the outcomes for Germany. The figure presents the outcomes for three years. In the first year, there was no stimulus, in the second, there was a fiscal stimulus in France, and the third year was the year following the stimulus.

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Figure 14.16 Successes and failures of the French fiscal stimulus (1980–1983).

OECD. 2015. OECD Statistics.

If you look at Figure 14.16, you will see that the budget balance in France (measured as (T − G)/Y) becomes negative. We can read this as saying that from a balanced budget in 1980, there was a budget deficit of nearly 3% of GDP in 1982, which increased further by 1983.

Meanwhile, in Germany, the budget remained close to balance through the three years. The budget surpluses were 0%, 0%, and 0.2% respectively.

The expansionary demand policy in France was an exception in Europe. There was an initial boost to French growth in 1982 (from 1.6% to 2.4%) but it quickly vanished, with growth falling back to 1.2% in 1983. Why?

The upturn in the French economy led French households to increase their spending, but much of this was on foreign goods. The French stimulus spilled over to countries that produced more competitive products, like Japan (electronic goods) and Germany (cars). There was a surge of imports into France: measured relative to the level in 1979, imports were higher by 17.9%, as shown in Figure 14.16. Germany’s exports were higher by 17.1% in 1982 and by nearly 14% in 1983. As a result, GDP growth was higher in Germany than in France in 1983. The French stimulus policy mostly benefitted its trading partners who had more competitive goods. France slipped behind the pack of European countries, with lower growth and a high government budget deficit (above 3% in 1983).

The failure of Mitterrand’s policy was reflected in economic terms by pressure on the French franc (the unit of currency during the period). Between 1981 and 1983, the French government had to devalue the franc three times in an effort to make French goods more competitive with those produced abroad. Mauroy stepped down in 1984 and the new prime minister introduced an austerity policy.

The Mitterrand experiment highlights the limits of using a fiscal stimulus to successfully stabilize a deep recession. In the case of France, the policy was badly designed and it delayed the adjustment of the French economy to the shocks that had affected it in the 1970s. Note that the problem in France was not only high unemployment. Injecting more aggregate demand stimulated spending, but not spending on French output.

A fiscal stimulus may not be the only (or best) policy option in a recession: Olivier Blanchard, the former chief economist of the IMF, explains how fiscal consolidation worked in the case of Latvia in 2008, even though he had initially advised against it.13

The multiplier was very low and the spillover effects to other economies meant that most of the stimulus leaked out of France. Had the major Euro­pean economies adopted fiscal expansionary policies simultaneously the results would have been different, as the spillover effects of Germany, say, would have stimulated the French economy. This is an example of poor policy­making due to a failure to understand the country’s links with the rest of the world. It would fit in the final row of the third column in Figure 14.12.

Assume the world is made up of just two countries, or blocs, called North and South. The world is in a deep recession. The situation can be described using the coordination game used for investment in Unit 13. Here the two strategies are Stimulus and No stimulus.

Explain in words how the coordination game reflects the problems faced by policymakers in the two countries that arise because of their interdependence.

Figure 14.16 shows the effects of France’s increased government spending and tax cuts in 1982 on the economies of France and Germany.

Based on this information, which of the following statements are correct?

• The French budget balance worsened by more than 3% as a result of the fiscal expansion.
• The fiscal expansion successfully resulted in a long-run shift in the French GDP growth rate to above 2%.
• The German economy benefitted from the spillover effect of higher French imports of German goods.
• Fiscal expansionary policy should never be adopted by European economies, as they have high levels of trade with each other.

• In 1983, G − T was below −3%, compared with 0 in 1980.
• The GDP growth rate did increase to above 2% in the year of fiscal expansion (1982). However this quickly fell back to near 1% in 1983.
• German exports were much higher in 1982–1983 than in 1979–1980.
• The fiscal expansionary policy can be effective if all countries adopted expansionary policies simultaneously.

14.10 Aggregate demand and unemployment

We now have two models for thinking about total output, employment, and the unemployment rate in the economy:

• The supply side (labour market) model: One model, set out in Unit 9, is of the supply side of the economy and focuses on how labour is employed to produce goods and services. This is called the labour market model (or the wage-setting curve and price-setting curve model).
• The demand side (multiplier) model: The other is of the demand side of the economy and explains how spending decisions generate demand for goods and services and, as a result, employment and output. This is the multiplier model.

When we put the models together, we will be able to explain how the economy fluctuates around the long-run labour market equilibrium over the business cycle.

The labour market model from Unit 9 is shown in Figure 14.17, and the equilibrium in the labour market is where the wage- and price-setting curves intersect. We will see that the economy tends to fluctuate over the business cycle around the unemployment rate shown at point A. In the example in Figure 14.17, the unemployment rate at equilibrium is 5%.

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Figure 14.17 The supply side of the aggregate economy: The labour market.

Figure 14.18 places the multiplier diagram beneath the labour market diagram. Note that in the labour market diagram, the horizontal axis measures the number of workers, so we can measure employment and unemployment along it. In the multiplier diagram, output is on the horizontal axis. The production function connects employment and output, and in this model, the production function is very simple.

We assume that labour productivity is constant and equal to λ (‘lambda’), so the production function is:

To allow us to draw the demand-side model underneath the supply-side model, we assume λ = 1, and so Y = N.

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Figure 14.18 The supply side and the demand side of the aggregate economy.

Short-term fluctuations in employment are caused by changes in aggregate demand. As we saw in Unit 9, when employment is below the labour market equilibrium because of deficient aggregate demand, the additional unemployment is called cyclical unemployment. If there is excess demand, above labour market equilibrium, then unemployment is below its equilibrium level.

In Figure 14.19, the economy is initially at labour market equilibrium at point A with unemployment of 5%. The level of output here is called the normal level of output. This means that the level of aggregate demand must be as shown by the aggregate demand curve labelled ‘normal’. Any other level of aggregate demand would produce a different level of employment.

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Labour market equilibrium

The economy is initially at labour market equilibrium at point A with unemployment of 5%. The level of aggregate demand must be as shown by the aggregate demand curve labelled ‘normal’.

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A boom

Consider a rise in investment that shifts the aggregate demand curve up to AD (high), so that output and employment rise. The economy is at B: with the boom, unemployment falls below 5%. The additional employment is called cyclical employment.

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A slump

If the aggregate demand curve shifts down, then through the multiplier process, output and employment fall to C. Unemployment rises above 5%. The additional unemployment is called cyclical unemployment.

In our study of business cycle fluctuations using the multiplier model, we have made a number of ceteris paribus assumptions. We have assumed that prices, wages, the capital stock, technology, and institutions are constant. We use the term short run to refer to these assumptions. The purpose of the model is to predict what happens to output, aggregate demand, and employment when there is a demand shock (a shock to investment, consumption or exports), or when policymakers use fiscal policy or monetary policy to shift the aggregate demand curve.

Notice that in Figure 14.19, the labour market is not in equilibrium when output is higher or lower than normal. The labour market model is a medium-run model where wages and prices can change, unlike in the multiplier model, which is a short-run model. So a short-run equilibrium in the multiplier model may not be a medium-run equilibrium in the labour market model.

• In Unit 15, the business cycle: We develop the model in Figure 14.19 by asking what happens to wages and prices in a boom and in a recession.
• In Unit 16, the long run: We use the wage-setting curve and the price-setting curves to study the long run, where output, employment, prices and wages can change, as well as institutions and technologies. We ask how changes in basic institutions and policies such as the weakening of trade unions, the increase in competition in markets for goods and services, or new labour-saving technologies will affect the aggregate economy.

The table in Figure 14.20 summarizes the different models we will use to study the aggregate economy.

Figure 14.20 Models to study the aggregate economy.

The following are the labour market and the multiplier diagrams, representing the medium-run supply side and the short-run demand side of the aggregate economy, respectively:

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Assume that the economy’s production function is given by Y = N, where Y is the output and N is the employment. Based on this information, which of the following statements is correct?

• A rise in investment shifts the AD curve up, resulting in a higher aggregate output. This causes the price-setting curve to shift up in the short run, leading to higher employment.
• A fall in autonomous consumption shifts the AD curve down, resulting in a lower aggregate output. This causes the wage-setting curve to shift to the left in the short run, leading to higher unemployment.
• Labour productivity shifts with the changes in aggregate demand in the short run.
• The shifts in the aggregate demand cause short-run cyclical fluctuations in unemployment around the medium-run level shown in the labour market diagram.

• In the short-run there is no shift in the price- or wage-setting curves. Instead, there are cyclical fluctuations in unemployment away from the medium-run level.
• In the short-run there is no shift in the price or wage-setting curves. Instead, there are cyclical fluctuations in unemployment away from the medium-run level.
• Labour productivity is assumed constant in the short-run.
• The labour market model determines the medium-run equilibrium while the aggregate demand model determines the short-run equilibrium.

14.11 Conclusion

Economies often experience shocks to aggregate demand, such as a decline in business investment or an increase in desired savings by households. These shocks tend to be amplified by the process described by the multiplier. In addition to their first-round effects, there are second-round or other indirect effects due to further declines in spending.

In the second half of the twentieth century, the advanced economies enjoyed a great decline in economic instability, which was due in part to larger governments and the existence of automatic stabilizers that moderated swings in aggregate demand.

While active fiscal policy played its part, it had a mixed record. France discovered in the early 1980s that a poorly planned fiscal expansion can lead to a fiscal deficit with little benefit to the domestic economy.

In 2008, the world was reminded that even the rich countries can suffer from economic crises, and the importance of fiscal policy in deep recessions was reaffirmed. Unfortunately for the Eurozone, the hardest-hit countries were unable to implement the necessary fiscal stimulus because of fears of sovereign debt crises.

Before you move on, review these definitions:

14.12 References

• Acconcia, Antonio, Giancarlo Corsetti, and Saverio Simonelli. 2014. ‘Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi-Experiment’. American Economic Review 104 (7) (July): pp. 2185–2209.
• Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua. 2010. ‘From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons’. Economic Policy 25 (62) (April): pp. 219–265.
• Auerbach, Alan, and Yuriy Gorodnichenko. 2015. ‘How Powerful Are Fiscal Multipliers in Recessions?’. NBER Reporter 2015 Research Summary.
• Barro, Robert J. 2009. ‘Government Spending Is No Free Lunch’. Wall Street Journal.
• Blanchard, Olivier. 2012. ‘Lessons from Latvia’. IMFdirect – The IMF Blog. Updated 11 June 2012.
• Carlin, Wendy and David Soskice. 2015. Macroeconomics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press. Chapter 14.
• DeLong, Bradford. 2015. ‘Draft for Rethinking Macroeconomics Conference Fiscal Policy Panel’. Washington Center for Equitable Growth. Updated 5 April 2015.
• Harford, Tim. 2010. ‘Stimulus Spending Might Not Be As Stimulating As We Think’. Undercover Economist Blog, The Financial Times.
• International Monetary Fund. 2012. World Economic Outlook October: Coping with High Debt and Sluggish Growth.
• Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Palgrave Macmillan.
• Keynes, John Maynard. 2004. The End of Laissez-Faire. Amherst, NY: Prometheus Books.
• Keynes, John Maynard. 2005. The Economic Consequences of Peace. New York, NY: Cosimo Classics.
• Krugman, Paul. 2009. ‘War and Non-Remembrance’. Paul Krugman – New York Times Blog.
• Krugman, Paul. 2012. ‘A Tragic Vindication’. Paul Krugman – New York Times Blog.
• Leduc, Sylvain, and Daniel Wilson. 2015. ‘Are State Governments Roadblocks to Federal Stimulus? Evidence on the Flypaper Effect of Highway Grants in the 2009 Recovery Act’. Federal Reserve Bank of San Francisco Working Paper 2013–16 (September).
• Portes, Jonathan. 2012. ‘What Explains Poor Growth in the UK? The IMF Thinks It’s Fiscal Policy’. National Institute of Economic and Social Research Blog. Updated 9 October 2012.
• Romer, Christina D. 1993. ‘The Nation in Depression’. Journal of Economic Perspectives 7 (2) (May): pp. 19–39.
• Shiller, Robert. 2010. ‘Stimulus, Without More Debt’. The New York Times. Updated 25 December 2010.
• Smith, Noah. 2013. ‘Why the Multiplier Doesn’t Matter’. Noahpinion. Updated 7 January 2013.
• The Economist. 2009. ‘A Load to Bear’. Updated 26 November 2009.
• Wren-Lewis, Simon. 2012. ‘Multiplier theory: One is the Magic Number’. Mainly Macro. Updated 24 August 2014.