Home > Uncategorized > Fiscal Policy I: The Spending Multiplier and the (False) Paradox of Thrift

Fiscal Policy I: The Spending Multiplier and the (False) Paradox of Thrift

I’m going to write down some of my thoughts on fiscal policy here mostly for the sake of organizing my thinking.  There are a few issues to tackle here so I intend to take it in two or three bites.

As I have said in the past, I have some gripes with the way that AS/AD is taught.  I have more of a monetarist view of aggregate demand so I like to think of it as PY=MV instead of Y=C+I+G+NX.  This becomes especially important when considering fiscal policy.  The textbook treatment makes essentially two claims.

Textbook claim 1: Deficit spending boosts aggregate demand

When government spending increases it increases G and this shifts aggregate demand to the right.  When taxes increase it decreases C which shifts AD to the left.  So the government can increase aggregate demand by taxing less or spending more or some combination of both that results in a larger deficit.  Theoretically, this can be done in a counter-cyclical manner (deficits in recessions and surpluses during expansions) in order to smooth out the business cycle.  It’s pretty obvious that it doesn’t happen this way in practice but that’s a subject for another time.

Textbook claim 2: Even deficit-neutral spending can increase AD because of the spending multiplier.

Basically, because people don’t consume their entire income, if the government takes some of it and spends it, it will go back to them as income and they will spend just as much but we will get the government spending on top of the private consumption spending which means higher aggregate demand.  Or in other words, if we raise taxes and government spending by the same amount, the decrease in C will be smaller than the increase in G.

There were several things that bugged me about these claims when I was a student, and I’ve seen some of my more talented students grapple with the same issues.  The problem is that this Keynesian model contradicts much of the other stuff we tell them in a macro principles class.  The most obvious example of this is the “paradox of thrift.”

Savings=Destruction……or was it Investment?

We spend half the class telling students that saving equals investment.  This is very sensible.  In order for someone to invest, someone has to save.  This is one of those deep truths that economics is built on.  Problem is, as soon as we get to AS/AD we start saying silly things like “assume that people only consume x% of their income and they save the rest.” And from this we come to conclusions like “if the marginal propensity to consume increases, C increases and that increases AD.”  Or textbook claim #2 above.  But these conclusions only follow from the assumption that “saving” in this context is destruction.

A smart-Alec, teacher’s-pet type who has been paying attention and thinking carefully up to this point might ask the question: “Wait, if people want to consume more of their income and save less, isn’t that exactly the type of thing we just got done saying shifts the supply of loanable funds/goods to the left and causes a decrease in investment?  Does it really make sense to just ignore the effect on investment?  And if we don’t just ignore it, won’t it completely annihilate these claims we are making?  And doesn’t the answer to that last question imply an answer to the second-to-last question?  And which parts of this are going to be on the final?”

These are almost all fantastic questions.  So how do you answer them? Maybe smarter people who have been teaching this longer have good answers within the CIG framework.  However, I’m skeptical.  As far as I can see, that framework is not capable of dealing with stuff like this and that is a real problem!  These little contradictions lurking under the surface make it so that the more carefully you think about what you are being taught, the less sense it all makes and that’s super annoying.

So what can be done?  Well, you can re-frame aggregate demand in a monetary way.  Let aggregate demand be PY=MV.  This doesn’t necessarily change any implications of the model but it forces you to talk about the things that affect aggregate demand in a monetary way.  And this is appropriate because aggregate demand is a fundamentally monetary phenomenon.  And this is what the Keynesian perspective is overlooking.

So now what can we say about fiscal policy in this MV framework?  Well any affect on aggregate demand must be either from a change in M or a change in V.  We could get these.  But in order to figure out what is really going on we have to ask a couple questions.

Question 1: Is the spending funded by increased taxes?

If yes: OK, then consumption and/or investment probably went down.  So it depends how much they went down.  This depends on the marginal propensity to spend.  Notice, that I am not talking about saving now.  Most of what people save is investment.  So it’s not their propensity to consume or save that matters.  We can lump all households and firms together and talk about what is actually at issue here, namely the willingness to hold money.

Note that if I “save” half of my income by buying a corporate bond or a stock, that money goes to a firm and they spend most of it on investment.  But there is one–and only one–type of “saving” that is destruction in the sense commonly proposed.  This is holding money. (Of course this is still hyperbole…) It’s the willingness to hold money, both by firms and households that determines velocity and therefore aggregate demand.  So if everyone holds 10% of their income in the form of money and we take some of it, spend it, then it goes back to them and they hold 10% of it still, we can increase aggregate demand by increasing both taxes and spending together in nearly the exact way described by the spending multiplier because this will increase velocity. This can even be shown mathematically rather easily.  You just have to change “saving” to “holding money” and “marginal propensity to consume” into “marginal propensity to spend” and the spending multiplier basically becomes velocity.  I love it when a plan comes together!

Now, the smart-Alec, Keynesian is probably thinking: “so if it works out the same, what difference does it make?”  The difference is that now I have explained it without saying something idiotic that contradicts a bunch of stuff I was saying a week ago.

No, the government spending is funded by deficits: Proceed to question 2.

Question 2: Who are they borrowing from?

If the private sector: Then this must affect the market for loanable funds in the way described above.  Specifically, the demand must increase  which will cause an increase in real interest rates and crowd out some private consumption as well as some private investment.  Does this change aggregate demand?  Maybe.  A first approximation would be to say that the sum of the private consumption and investment crowded out would be exactly equal to the amount of government spending.  This is what you would see if you just look at a partial equilibrium in the loanable funds market and assume the private supply and demand are unchanged.  However, disturbing this market may very well affect the willingness to hold money which will affect velocity and may have some effect on velocity and therefore aggregate demand.  However, this is much more suble than just saying “G increases and C stays the same.”

If the central bank: Ok, let’s say you have the government borrow money but instead of dipping into the private market and pulling loanable funds away from consumers and investors, their spending is actually financed by the creation of additional money by the central bank.  Now we will almost certainly see an increase in aggregate demand as we will see a pure increase in the desire to purchase goods and services without any direct offsetting decrease in some other sector (much like what is commonly assumed).  But in our MV model, this is easy to see.  It’s just an increase in M.  Unless it causes a corresponding decrease in V for some reason it will be an increase in aggregate demand.  But then is it actually fiscal policy or is it monetary policy?

In my opinion this last case is the most important one and is the source of a considerable amount of bickering about the efficacy of “fiscal policy” especially in the presence of a “liquidity trap” or the zero lower bound.  I will leave these issues for later but I think the paradigm in the principles texts makes it very difficult to sort these things out.  Mine is better.

[By the way, note that if the central bank is targeting an interest  rate, then an increase in demand for loanable funds caused by an increase in government spending may very well cause an increase in the money supply in a way that would appear automatic in the sense that no explicit action would be observed on the part of the central bank.  In other words, the same interest rate target might become more expansionary monetary policy in the presence of deficit spending.  In this case was fiscal policy effective?  Was it necessary?  It depends.  Are you a Keynesian or a monetarist?]


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