EC2B3 Macroeconomics II

Topic 10: Financial Markets and Fiscal Policy

(Week 11)

Kevin Sheedy
LSE
Winter Term 2024
Fiscal policy
 Fiscal policy
• We have studied how monetary policy affects the economy
• But monetary policy may sometimes be ineffective, e.g. at lower bound
• Governments may be able to use fiscal policy as an alternative
• To manage aggregate demand and try to stabilize business cycles
• For example, tax cuts or increased public spending in recessions
• What determines the impact of fiscal policies on real GDP?
• There are some reasons to think the effects might be small:
• Government budget constraint: more debt means higher taxes in the future
• ‘Crowding out’: expansionary fiscal policy raises interest rates, which displaces
private consumption and investment expenditure, reducing overall boost to GDP
• We also explore some reasons why effects might be larger: ‘multipliers’
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 Budget constraints and Ricardian equivalence
• Household present-value budget constraint:
𝐶′
Current taxes cut 𝐶′ 𝑌′ − 𝑇′
𝐶+ =𝑌−𝑇+
from 𝑇1 to 𝑇2 1+𝑟 1+𝑟
• Passes through (𝑌 − 𝑇, 𝑌 ′ − 𝑇 ′ ), shifts right
• Government present-value budget constraint:
1+𝑟 𝐺′ 𝑇′
1 𝐺+ =𝑇+
𝐶 ′∗ 1+𝑟 1+𝑟
• Unless 𝐺 or 𝐺 change, lower 𝑇 means 𝑇 ′ rises
′
𝑌′ − 𝐺 ′ • Eliminating taxes from two budget constraints:
𝐶′ 𝑌′ − 𝐺 ′
𝑌 ′ − 𝑇1′ 𝐶+ =𝑌−𝐺+
1+𝑟 1+𝑟
𝑌 ′ − 𝑇2′ • 𝑌 − 𝑇, 𝑌 ′ − 𝑇 ′ down and to right; no shift in
budget constraint as (𝑌 − 𝐺, 𝑌 ′ − 𝐺 ′ ) constant
∗
𝐶 • Ricardian equivalence: no change in 𝐶
𝐶∗ 𝑌 − 𝐺 𝑌 − 𝑇1 𝑌 − 𝑇2
• Save tax cut because future taxes higher 4
 ‘Crowding out’
• Ricardian equivalence does not rule out a direct
𝑟 increase in public spending 𝐺 raising real GDP
• Consider temporary increase in 𝐺 (𝐺 ′ unchanged)
𝑌1𝑠
𝐺↑ 𝑌2𝑠 • Analysis in closed economy: 𝑌 𝑑 = 𝐶 𝑑 + 𝐼 𝑑 + 𝐺
𝐶𝑑 ↓ 𝑁𝑠 ↑ • Higher 𝐺 directly shifts 𝑌 𝑑 rightwards
• But increases tax burden: 𝑇 + 𝑇 ′ /(1 + 𝑟) up
• Wealth effects: Lower 𝐶 𝑑 , higher 𝑁 𝑠
𝑟2 • But only temporary increase in 𝐺, so desire for
𝑟1
consumption smoothing means 𝐶 𝑑 falls by less
𝑌2𝑑
• Overall, 𝑌 𝑑 shifts to the right
𝑌1𝑑
• 𝑌 𝑠 also shifts right (due to wealth effect on 𝑁 𝑠 )
• Increase in 𝐺 boosts GDP 𝑌, but less than 1-for-1
𝑌 • 𝑌 𝑑 shifts by larger amount than 𝑌 𝑠 : 𝑟 rises
𝑌1 𝑌2
• Higher interest rate reduces 𝐶 𝑑 and 𝐼 𝑑
• ‘Crowding out’ effects reduce impact on 𝑌 5
Keynesian multipliers: Aggregate
demand with credit constraints
 Aggregate demand multiplier
• Demand shocks affect real GDP 𝑌 in the models seen so far
• Higher GDP means higher income: which means higher
consumption and even higher demand, higher GDP, and so on…?
• But this feedback loop, or ‘multiplier’, did not feature in earlier
analysis of the output demand curve:
• Valid when households do not face credit constraints and level of
employment is socially optimal (meaning 𝑀𝑃𝑁 = 𝑀𝑅𝑆𝑙,𝐶 )
• Under these conditions, only the direct effect of shocks in making households
better off or worse off should matter for consumption demand
• But in New Keynesian model, 𝑀𝑃𝑁 > 𝑀𝑅𝑆𝑙,𝐶 , so more employment and
income is a net gain for households: consumption demand rises with 𝑌
• And credit constraints imply higher 𝑌 makes some households better off 7
 Consumption with binding credit constraint
• Assume some households face a binding
𝐶′
maximum borrowing limit :
• Cannot get enough current income to pay for
desired consumption, and cannot borrow
enough against future income
𝑌′ − 𝑇′
• Budget constraint truncated
𝐶 ′∗ • Not all are constrained: some are savers

• For credit-constrained households:

• Current consumption 𝐶 rises 1-for-1
with disposable income 𝑌 − 𝑇
• Diagram shows case where current income 𝑌
Maximum
borrowing
rises, but argument works for tax changes too
• Current consumption does not
𝐶
respond to future taxes 𝑇 ′
𝑌1 − 𝑇 𝑌2 − 𝑇 𝐶1∗ 𝐶2∗ • Ricardian equivalence fails
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 Output demand with multiplier
• Consumption demand 𝐶 𝑑 is now directly a function of income 𝑌
• Sensitivity of 𝐶 𝑑 to higher 𝑌 is marginal propensity to consume (𝑀𝑃𝐶):
𝜕𝐶 𝑑 (𝑌)
𝑀𝑃𝐶 =
𝜕𝑌
• 𝑀𝑃𝐶 for aggregate consumption is a weighted average of the 𝑀𝑃𝐶 of 1
for credit-constrained households and the lower 𝑀𝑃𝐶 of savers
• Output demand in closed economy is 𝑌 𝑑 = 𝐶 𝑑 (𝑌) + 𝐼𝑑 + 𝐺
• Consumption demand 𝐶 𝑑 (𝑌) depends on income 𝑌
• In equilibrium, aggregate income equals aggregate demand: 𝑌 = 𝑌 𝑑
• Plot expenditure function 𝑌 𝑑 against output and income 𝑌
𝜕𝐶 𝑑 (𝑌)
• Gradient is marginal propensity to consume , between 0 and 1
𝜕𝑌 9
 Keynesian multiplier effect
• In equilibrium, level of output demand lies
𝑌𝑑
on the 45∘ line where 𝑌 𝑑 = 𝑌
45∘
• Any factors affecting 𝑌 𝑑 other than income
𝑌 shift the expenditure line 𝑌 𝑑 vertically
𝑌2𝑑
Direct effect of
demand shock 𝑌1𝑑 • 𝑀𝑃𝐶 between 0 and 1 boosts effect on 𝑌 𝑑
𝑌2 Direct effect
𝑀𝑃𝐶 Total effect =
1 1 − 𝑀𝑃𝐶
𝑌1
Multiplier • 𝑌 𝑑 curve in (𝑌, 𝑟) space shifts by more
effect horizontally when a demand shock occurs
• Amplifies effect of demand shocks on 𝑌
• Keynesian ‘multiplier’ effect
𝑌
𝑌1 𝑌2 • 𝑌 𝑑 is also now flatter: more sensitive to 𝑟
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Fiscal policy: Multipliers
versus crowding out
 Multipliers versus crowding out
• What might change earlier analysis of weak effect of fiscal policy?
• Supply-side effects of government expenditure on infrastructure:
• If raise current TFP, boost 𝑁 𝑑 and 𝑌 𝑠 ; if raise future TFP, boost 𝐼 𝑑 and 𝑌 𝑑
• 𝑌 𝑑 could shift by more than 𝐺 increases; 𝑌 𝑠 shift is larger than wealth effect
• Some households are credit constrained: multiplier effects on demand
• Prices are sticky and monetary policy is accommodative
• Re-examine fiscal policy with focus on second and third of these
• Temporary increase in government expenditure 𝐺
• Financed by borrowing: no rise in current taxes 𝑇, only higher 𝑇 ′
• Credit-constrained households consume disposable income
• Monetary policy maintains constant real interest rate 𝑟 12
 Effects of a fiscal stimulus
• If no credit constraints, horizontal shift of 𝑌 𝑑 is
𝑟 𝑌1𝑠
𝑌2𝑠 smaller than increase of 𝐺
• ‘Crowding out’ due to higher future taxes

𝑟2∗ • With credit-constrained households, shift of 𝑌 𝑑

becomes larger and can exceed increase of 𝐺
𝑟1 𝑀𝑀
• Credit-constrained households have 𝑀𝑃𝐶 of
1 from current disposable income 𝑌 − 𝑇
• Do not react to higher future taxes 𝑇 ′
𝑌2𝑑
• Wealth effect from higher tax burden reduces
𝑌1𝑑 𝐶 𝑑 only for those not credit constrained

𝑌 • Monetary policy holds 𝑟1 constant (no 𝑀𝑀 shift)

𝑌2
𝑌1 • No ‘crowding out’ due to 𝑟 rising to 𝑟2∗
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Money and public finance
 Money and public finance
• Governments derive fiscal advantage from being able to issue fiat
money that is demanded by the private sector
• Unlike bonds, no obligation to ‘repay’ or redeem fiat money
• Money may pay no interest, or if interest is paid (e.g. interest on
reserves 𝑖𝑟 ), the rate can be below the interest rate on bonds (𝑖𝑟 < 𝑖)
• Fiscal gains from issuing money are known as ‘seigniorage’
• These fiscal gains are an implicit tax on holders of money
• How to quantify the size of the fiscal gains arising from different
monetary policies?

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 Printing money
• If the money supply is growing at rate 𝜇 then an amount of new
money 𝜇𝑀 is created in each time period
• If directly used to finance government expenditure, this
seigniorage revenue is directly worth 𝜇𝑀Τ𝑃 in real terms
• Fiscal advantage from ‘printing money’
• This is the simplest and most direct measure of seigniorage
• Though calculation ignores saving of regular interest payments on past
spending that was financed in this way rather than by issuing bonds
• But aside from in hyperinflations, the more typical case is that the
central bank buys assets when new money enters circulation
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 Central-bank investment profits
• Assume first money pays no interest (no interest on reserves),
and all money created by central bank used to buy nominal bonds
• Central bank holds bonds of value 𝑀, matching the supply of money
• CB earns interest 𝑖𝑀 each time period, and with no interest paid on
money or other costs, these are profits paid out to the finance ministry
• Real seigniorage revenues are 𝑖𝑀/𝑃
• This is a flow of seigniorage that is received in each time period
• Different from measure based on value of increase in the money supply
• Even when central bank does not buy assets, 𝑖𝑀/𝑃 still accurately
measures fiscal advantage from steady money supply growth
• Seigniorage is reduction in government borrowing costs by issuing
money rather than bonds: money’s financial return is lower than bonds
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 Limits to size of real seigniorage revenues
𝑀 • As seigniorage arises from money being a less
𝑖
𝑃 good store of value than other assets, it is an
implicit tax on holders of money
• Identical to forgone interest in analysis of
money demand (see Topic 7)
• But if money is a relatively worse store of
value (higher 𝑖) then money demand is lower
• 𝑀𝑑 Τ𝑃 = 𝐿(𝑌, 𝑖) is decreasing in 𝑖
• Real seigniorage revenue = 𝑖𝑀Τ𝑃 = 𝑖𝐿(𝑌, 𝑖)
• Zero for 𝑖 = 0; zero again for very high 𝑖 if
money demand 𝐿(𝑌, 𝑖) falls towards zero
sufficiently fast as 𝑖 increases
• ‘Laffer curve’ for real seigniorage revenues
0
0
𝑖 • Maximum seigniorage revenue at top
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 Another look at central-bank investment profits
• Measure of CB profits 𝑖𝑀/𝑃 assumes no interest is paid on
money, and that CB buys only safe, short-term bonds as assets
• If interest 𝑖𝑟 is paid on reserves then this reduces CB profits:
• If all monetary base pays interest 𝑖𝑟 , CB profits are 𝑖 − 𝑖𝑟 𝑀/𝑃
• Seigniorage eliminated by floor system (𝑖 = 𝑖𝑟 )
• Like following the Friedman rule (𝑖 = 0) when all money is physical cash
• Other CB standing facilities (if used): higher 𝑖𝑏 can raise CB profits
• CB might buy long-term bonds or other risky assets:
• If hold long-term bonds with yield 𝐼, steady-state profits = 𝐼 − 𝑖𝑟 𝑀/𝑃
• Higher average profits if there is a risk premium (𝐼 − 𝑖 > 0)
• But CB makes losses if 𝑖𝑟 rises above yield when bonds were bought
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 The inflation tax
• As well as flows of seigniorage, monetary policy can also lead to
capital gains/losses on nominal bonds such as government debt
• Ex-post real return = past nominal interest rate − actual inflation rate
• With an unpredictable increase in inflation 𝜋 and the nominal interest
rate on existing bonds set in the past, the real value of debt declines
• Fiscal advantage from surprise inflation known as ‘inflation tax’
• Distinct from seigniorage defined earlier (which is only from money)
• Note that inflation-indexed bonds are protected from surprise inflation
• And inflation tax works only for ‘surprise’ inflation: real return protected
from expected inflation as nominal interest rate 𝑖 can adjust in advance
• Though for longer-term nominal bonds, the real return is affected by any
surprises to inflation after issuance of the bond until its maturity is reached
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 Summary
• Effect of fiscal policy on GDP is weakened by ‘crowding out’ of
private consumption and investment spending
• Through anticipation of higher taxes, or through higher interest rates
• However, there can be Keynesian ‘multiplier’ effects that boost
the impact of fiscal policy: higher income raises consumption
• Particularly when many households face binding borrowing constraints
• Monetary policy has implications for the government’s budget:
• Central bank makes profit if money offers lower return than other assets
• However, real seigniorage revenue is limited by the demand to hold money
• Profits can be larger if long-term bonds purchased, but there is a risk of losses
• Real value of nominal bonds eroded by surprise increase in inflation
• Particularly so if government has issued long-term bonds 21