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Lecture 8

MGEA06H3 Lecture Notes - Lecture 8: Government Budget Balance, Output Gap, Ricardian Equivalence

Economics for Management Studies
Course Code
Iris Au

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Effectiveness of Fiscal Policy
Expansionary and Contractionary Fiscal Policy
Since changes in G, T0, and TR0 lead to changes in AE0, changes in fiscal
policy will shift the AEPlanned and AD curves changes in Y (Chapter 12)
Changes in fiscal policy that will lead to an increase in output is called
expansionary fiscal policy (i.e., G , T0 , TR0 ).
Changes in fiscal policy that will lead to a decrease in output is called
contractionary fiscal policy (i.e., G , T0 , TR0 ).
Can Expansionary Fiscal Policy Actually Work?
Last week, we showed that expansionary fiscal policy can be used to close a
recessionary gap; however, not everyone believes the use of fiscal policy to
smooth out business cycles will work for the economy.
Claim 1: “Government Spending Always Crowds Out Private Spending”
Argument: Every dollar that the government spent is a dollar taken away
from the private sector. So, any increase in government spending MUST be
offset by an equal reduction in private spending.
Counter argument: This argument is only true if the economy is operating at
full-employment, in which output is held fixed.
ÞHowever, if the economy is facing a recessionary gap, then expansionary
fiscal policy works (Chapter 12).
MGEA06 – Week 8 Iris Au 1

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Claim 2: “Government Borrowing Always Crowds Out Private Investment
Argument: Expansionary fiscal policy lowers public savings supply of
loanable funds interest rate investment (the crowding out effect
discussed in Chapter 10).
Counter-argument: The crowding out on investment is less likely to happen
because when the economy is in a recessionary gap, an expansionary fiscal
policy is likely to increases output/income. Given households only consume
a portion of the income, national savings would increase and interest rate
won’t increase.
Claim 3: “Government Budget Deficits Lead to a Reduced Private Spending”
Argument: Holding all else constant, expansionary fiscal policy might lead
to budget deficit. To finance the budget deficit, the government borrows
from the public stock of national debt .
ÞTo pay off the debt, the government have to raise taxes. Anticipating
increase in taxes in the future, households save more and spend less now
expansionary fiscal policy have no effect on output Ricardian
Counter-argument: It is unlikely that households will behave with such
foresight and budgeting discipline. Even they do, they might spread the
reduction in consumption over a long period time. Therefore, expansionary
fiscal policy can still increase output (but by a smaller amount). Fiscal
policy becomes less effective but NOT completely ineffective.
MGEA06 – Week 8 Iris Au 2
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