Taxes, all else equal, reduce demand by lowering disposable income. If federal spending rises faster than taxes and deficits increase, economywide aggregate demand gets a boost.
Higher demand in turn induces firms throughout the economy to hire more people and this leads in turn to lower unemployment. As roads are built or as more people receive transfers from the federal government, this leads to greater demand for concrete, steel, capital equipment, restaurant meals, and so on.
This in turn leads to increased demand for workers to produce these goods and services. This boost to demand stemming from larger budget deficits is precisely why it is almost universally recommended to run larger deficits when the economy enters recession and is starved of demand.
This stimulus to aggregate demand, however, is also the reason many worry about potential malign effects of deficits. If deficits rise when the economy is already characterized by full employment—meaning economywide resources like labor and capital are already fully utilized—then the boost to aggregate demand created by these larger deficits can be accommodated only by crowding out already-occurring spending.
In the current institutional framework of the U. The Fed raises rates in the face of higher budget deficits run during times of full employment because they worry that the boost to aggregate demand caused by larger deficits could stoke inflationary pressures.
If this happened when the economy was already at full employment, there would be no workers or equipment available to produce the extra goods and services needed to satisfy the new demand as households went out and tried to spend these debit cards. In turn, greater demand meeting unchanging supply would lead to general increases in prices, or inflation. Higher interest rates would increase the costs for durable goods purchases financed with debt think autos and houses and washing machines , thereby lowering demand for these goods.
Higher rates would also make it harder for firms to borrow money to invest in tangible plants and equipment think of a restaurant owner deciding whether or not to take out a loan to replace the furniture in his dining room.
Finally, higher interest rates increase foreign demand for U. The resulting stronger dollar makes U. S households, which increases the trade deficit and reduces demand for U. In short, larger budget deficits run when the economy is already at full employment can threaten to crowd out investment in tangible capital by businesses, and can lead to higher foreign ownership of U. This in turn can potentially lead to slower productivity growth as the investment slowdown deprives U.
Both of these channels can make future generations poorer than they would have been absent the increase in the deficit. Occasionally the claim is made that the sole indicator that budget deficits have become too large is accelerating inflation.
If there was a long-term debt problem, the way that you would know that is that there would be a long-term inflation problem. This seems clearly wrong and seemingly rests on an assumption that the Federal Reserve would not raise interest rates in response to a real or perceived excess of aggregate demand over productive capacity caused by larger deficits.
This outlook does not project rising inflation in the face of the excess growth of aggregate demand over productive capacity even though this excess growth is clearly being forecast. The reason CBO does not project accelerating inflation in the face of excess growth of aggregate demand caused by deficits is obvious: They assume the Fed will still exist in the future and that it will be successful in meeting its inflation mandate, and this success will rest on higher interest rates.
Often proponents of MMT express a preference for taking the primary mandate for controlling inflation away from the Fed; these proponents even argue that the proper stance of Fed interest rate policy is to hold short-term rates at zero, always and everywhere. Regardless of what one thinks about taking the primary mandate for inflation control away from the Fed and handing it to fiscal policymakers, we should be clear that this would be a big change from the institutional structures that currently exist in the American economy.
Given the existence of these institutions, economic predictions based on the idea that the Fed would not react to a real or perceived excess of aggregate demand over productive capacity by raising interest rates would be wrong. None of the malign effects of deficits happen if they are incurred when the economy has excess productive slack jobless potential workers or excess capital capacity.
In this case, as households rushed out to spend this extra money, there would be idle resources that could be mobilized to produce the extra goods and services that are newly demanded. This implies that it is output GDP , not prices, that will be pushed up by the boost to desired spending. Since this does not threaten to push up inflation so long as the economy retains productive slack, there is no need for the Fed to raise interest rates, and the channels of crowding out do not operate.
In fact, because larger deficits ensure a steadier stream of customers, these deficits can induce firms to make sure their investment in tangible plants and equipment does not fall off the way it would in an economic downturn.
So far we have been discussing how a change in the size of the budget deficit affects aggregate demand. However, the relationship between deficits and aggregate demand and hence the pace of overall growth is decidedly two-way.
If a negative shock to private spending causes the economy to slow or enter recession, then this will mechanically feed back to larger federal budget deficits. As private-sector incomes fall, tax collections fall. And as more people become eligible for safety net programs as the private sector contracts, federal spending rises. This increase in the deficit that results from slowing economic conditions is unambiguously a good thing.
A key issue that fiscal policymakers should strive to address going forward is making these automatic stabilizers larger and longer-lasting as the economy slows. While automatic stabilizers and discretionary fiscal stimulus both worked to support the economy during the 18 months of the Great Recession, fiscal policy turned sharply contractionary far too early in the subsequent recovery.
As we have discussed above, when there is productive slack in the economy, any increase of public spending that is not financed by higher taxes will boost spending and create jobs.
If some of this increased public spending takes the form of investment—spending that yields an asset that will make society richer in the future—then so much the better for sustaining economic growth. Obvious candidates for public investment include core infrastructure and early child care and education.
For example, the Supplemental Nutrition Assistance Program SNAP, sometimes referred to as food stamps and Medicaid a program that provides health insurance to poor families have both been shown to significantly increase future health and labor market outcomes for children who benefited from these programs.
Furthermore, even when the economy is at full employment, public investments that are debt-financed likely do not damage future economic growth prospects and may well even boost them. Remember, the key reason why larger budget deficits run during times of full employment potentially damage future growth is because they can push up interest rates and crowd out private-sector investments in productive plants and equipment.
But if the deficits that crowd out private investment are themselves financing productive public investments, then future growth may well not be slower. If the debt-financed public investments are as productive as the private-sector investments they might displace, then they will not drag on growth. Given that the last generation has seen a sharp slowdown in the accumulation of public capital, public investments may well have a higher social return than private investments.
The intuition that it might be fine to finance public investments with debt even when there is no economywide demand slack is most clear when the public investments are aimed at slowing greenhouse gas emissions. If the bulk of these investments are relatively time-limited—e. Fiscal stimulus is politically difficult to reverse. Whether it has the desired macroeconomic effects or not, voters like low taxes and public spending.
Eventually, economic expansion can get out of hand—rising wages lead to inflation and asset bubbles begin to form. High inflation and the risk of widespread defaults when debt bubbles burst can badly damage the economy and this risk, in turn, leads governments or their central banks to reverse course and attempt to "contract" the economy.
In the face of mounting inflation and other expansionary symptoms, a government can pursue contractionary fiscal policy , perhaps even to the extent of inducing a brief recession in order to restore balance to the economic cycle. The government does this by increasing taxes, reducing public spending, and cutting public-sector pay or jobs.
Where expansionary fiscal policy involves deficits, contractionary fiscal policy is characterized by budget surpluses. This policy is rarely used, however, as it is hugely unpopular politically.
Public policymakers thus face a major asymmetry in their incentives to engage in expansionary or contractionary fiscal policy. Instead, the preferred tool for reining in unsustainable growth is usually a contractionary monetary policy , or raising interest rates and restraining the supply of money and credit in order to rein in inflation. Fiscal policy is enacted by a government.
This is opposed to monetary policy, which is enacted through central banks or another monetary authority. In the United States, fiscal policy is directed by both the executive and legislative branches. In the executive branch, the two most influential offices in this regard belong to the President and the Secretary of the Treasury , although contemporary presidents often rely on a council of economic advisers as well.
In the legislative branch, the U. Congress authorizes taxes, passes laws, and appropriations spending for any fiscal policy measures through its "power of the purse". This process involves participation, deliberation, and approval from both the House of Representatives and the Senate. Fiscal policy tools are used by governments that influence the economy.
These primarily include changes to levels of taxation and government spending. To stimulate growth, taxes are lowered and spending is increased, often involving borrowing through issuing government debt. To put the dampers on an overheating economy, the opposite measures would be taken. The effects of any fiscal policy are not often the same for everyone.
Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers.
A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts and firms, which would not do much to increase aggregate employment levels. One of the biggest obstacles facing policymakers is deciding how much direct involvement the government should have in the economy and individuals' economic lives.
Indeed, there have been various degrees of interference by the government over the history of the United States. But for the most part, it is accepted that a certain degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends.
International Monetary Fund. Fiscal Policy. Thus, it will certainly take time to reach a more stable and balanced international economic situation. This conference is not the place to decide the question of whether economics is a moral science, as Kenneth Boulding once put it. There is no use in asking who has to take the blame for the present disequilibria. The problem confronting us is simply due to the inability of the major industrialized countries to coordinate their policies. What conclusions do we have to draw?
First, I fully agree with Makin that there must be some burden-sharing between deficit and surplus countries. A lower rate of government spending in the United States would certainly help. In the Federal Republic of Germany, the increase in public deficits in the years to come will probably be more marked than it presently seems. I am not sure whether there is scope for a more expansionary monetary policy in Germany. To avoid a collapse of world trade, everybody is well-advised to abstain from protectionist measures.
The situation requires patience and self-control. Second, I also fully agree with the conclusion that flexible exchange rates do not allow one country to depart very much from the policies of other countries. The experiment of past years—that is, putting the burden of adjustment almost exclusively on the shoulders of the exchange rate—has proved to be very expensive. This is especially valid for countries with a large foreign sector. Wide exchange rate fluctuations in both directions tend to depress private investment over the whole cycle.
Third, if policy coordination in a highly interlinked world turns out to be insufficient, then the question arises of whether we need improvements in the exchange rate system, which will increase the obligation to coordinate policies. I shall not present a full-fledged discussion of his arguments, but will address a selected set of points that I regard as being of special interest for the conference.
In discussing these points, I shall roughly follow the order that Makin follows in his reasoning. One can broadly accept his account of the U. In this context, the terms of trade improved and output and employment expanded. There is, of course, an element of truth in this rather general statement, but it needs to be qualified, either by reference to the conditions specified in theoretical models or in the light of the abundant evidence collected in empirical studies of the U.
More specifically, the argument developed in the paper regarding the increasingly dualistic nature of the U. Needless to say, it would be interesting to see the relevant statistical evidence.
Has the shift really been so large, when account is taken of the lead times involved in investing in new operating facilities overseas? In addition, I find it hard to believe that U.
This would be an interesting contrast to the experience in Italy, where companies reacted to the strong exchange rate policy by reducing inefficiencies, cutting costs, and enhancing innovation. Surely, the recent strong export performance of the U.
One could actually buttress this argument with some empirical evidence about the relationships between saving and investment in the three major economies and the interplay between their current account balances. The results are similar if the changes are computed on a structural budget basis.
Comparable changes in the opposite direction occurred in the current account balances of the three countries: in terms of gross domestic product GDP , the U. My view is that the shifts in budgetary policies in the three countries, together with the relative stability of the financial balances desired by the private sector households, corporations, financial institutions , played a significant role in determining the movements in external payments through their influence on the pattern of domestic savings and investment.
These developments propagated economic growth in Europe and other areas of the world economy by way of the foreign trade multiplier and, as the paper correctly argues, provided a cushion for the fiscal retrenchment in the countries exporting to the United States. Several shocks have been simulated, of which the most interesting for the purposes of this discussion is a devaluation of the EMS currencies with respect to the dollar and an increase of domestic demand in the United States.
The exercise shows that the trade balances of the three countries respond significantly to changes occurring outside the EMS area, especially in aggregate demand.
Exchange rate changes have a smaller impact because the domestic price reaction dampens their effect on price competitiveness. In sum, the appreciation of the dollar and the faster growth of U. The benefits were especially important for France and Italy, since they came in a period when both nations were pursuing anti-inflationary policies that caused their real exchange rates to appreciate. Since no support was provided during that period by the sluggish demand growth in the low-inflation countries of the EMS, it is doubtful whether France and Italy would have been able to follow the same policies in the absence of the external stimulus provided by the United States.
The counterpart of the necessary correction in the U. These will obviously have to occur mostly in the rest of the OECD area, since we cannot count on the indebted developing countries in view of the fragility of their financial situation. Yet the reduction of the U. Rather, the adjustment should be managed smoothly and targeted to the major surplus countries.
This process would require differentiated demand policies in the OECD area outside the United States, so as to generate sufficient growth in domestic absorption and offset the negative impact of declining net exports to the United States while simultaneously reducing the existing payments imbalances. The importance of relative demand growth is also being boosted by the increasing priority the EMS countries are giving to stability in exchange rate relations.
The first concerns the issue of worldwide fiscal discord and its implications for the observed instability in currency and equity markets. It is, I think, more clearly recognized today, at least by some of the Group of Seven nations, that fiscal policy decisions should be better attuned to the needs of international adjustment; the stimulative action announced in by Japan is exemplary in this respect.
I am of the view that if the leading countries were able to negotiate a fiscal compromise involving less U. Yet, I see no mention of the possibility of such international policy coordination in the paper. The political complexities of the budgetary process in the United States mean that Professor Makin is probably right on this score. He then suggests that we may be facing a catastrophe: a sharp market reaction to the failure or inadequacy of policy decisions in the form of a further collapse of equity prices or a sudden rise in interest rates, resulting in a recession.
I find it hard to believe that such a negative scenario can be prevented by coupling fiscal restraint in the United States with easier money in Japan and Germany alone. I still believe that action is needed on the fiscal front as well, and that there is scope for such action in both countries.
So much has been written about the U. John Makin has wisely chosen to present a balanced account of the events since the beginning of this decade. That leaves the discussant with few bones to chew on.
I shall therefore concentrate on some theoretical points first, and then bring up the European receiving end of the U. This paper, as I see it, confirms the strong and growing recognition that the Mundell-Fleming model is after all the most efficient framework for interpreting the world macroeconomy.
This is amazing for three reasons. First, the Mundell-Fleming model is the open economy version of the IS-LM model that is hardly mentioned in some recent influential macroeconomics textbooks. Second, this model, which is now more than 25 years old, has none of the components that have so changed what graduate students learn and do nowadays, ranging from rational expectations to intertemporal maximization, including time-inconsistency and equilibrium business cycles.
The last reason is that the model is surprisingly robust to a large number of restrictive assumptions, probably setting a record in the application of the parsimony principle, which sometimes escapes modern users. For example, Makin notes that, contrary to a literal reading of the model, the recent experience has shown that fiscal policy is able to affect output under flexible exchange rates.
Remember that according to the Mundell-Fleming model, a fiscal expansion leads to an exchange rate appreciation, and the resulting trade deficit eliminates the impact of fiscal policy. In describing the effects of the investment tax advantage, Makin points out, quite interestingly, that U. One could push the advantage further and note that this is a perfect example of a successful case of time-inconsistency. Indeed, once the additional capital is in place, it may well be optimal to tax it in the U.
Forward-looking agents are not supposed to fall into such a trap, and yet they did! Or did they? This really brings me to one aspect that is overlooked by Makin—namely, the dynamic aspects of fiscal policy. Because any deficit budgetary or external leads to debt accumulation, stability conditions require that it be eventually compensated by a primary surplus that is at least sufficient to stabilize the ratio of debt to gross national product GNP , if not to bring the debt back down in initial level see Sachs and Wyplosz Thus, the eventual reversal of the U.
Whereas U. This is why it makes sense for the United States to hope for a demand expansion abroad when it can finally deal with its budget deficit. The question is whether it made any sense to shift investment spending intertemporally.
In order to answer this question, we must ask ourselves what would have happened in the absence of the investment tax incentives. With the savings rate notoriously unresponsive to policy actions notwithstanding the Ricardian equivalence principle , the investment tax concessions pushed all the adjustment onto the current account, thus financing the budget deficit through foreign borrowing, instead of crowding out investment.
The question raised above can now be answered as follows. With no investment tax advantage and percent crowding-out of private investment, the policy move would have been smart if the net social return of the budget deficit had exceeded the net social return of displaced investment. With the tax advantage and percent leakage to the current account, the criterion is now whether the net social return of the larger deficit exceeds the real cost of foreign borrowing.
A case can be made that the latter criterion is less stringent than the former although not necessarily that it is satisfied; this may depend, among other things, on future foreign demand for U. Yet, a superior alternative would have been to limit the sharp interest rate increase and the equally sharp dollar appreciation with a more accommodating monetary policy.
He notes that the reduction of the U. With a serious cut in the budget deficit slow in coming and hard to come by, the absorption can only be reduced through tight monetary policy or a negative wealth effect, or both. Hence, according to Makin, the financial markets simply anticipated the unavoidable. But then, why did stock prices plunge worldwide?
Is it not true that absorption should rise outside the United States to help with the adjustment? Are not the world financial markets providing the cure and the poison at the same time? For, if absorption falls overseas and reduces U. The same logic would interpret the simultaneity of crashes as an indication that the United States, where it all started, is pulling Europe into trouble. The truth is probably the opposite.
Stock prices fall because of lower expected profits, in present value terms. The latter comes as the consequence of a fall in output, not in absorption. If foreign demand for U. Thus, the crash cannot be explained only by reference to the U. The complete story must include the absence of faster growth overseas. The important issue, then, is why Europe has not taken the expansionary measures that could have prevented stock crashes worldwide. The first one is that the United States was an outlier once in —85 when it embarked on a strong fiscal expansion.
It now has to face the second stage of that policy, stabilizing its public debt and, hence, being an outlier again. Although cooperation is, in theory, superior to noncooperation, it does not follow that the rest of the world should always play seesaw with the United States. Indeed, some writers have suggested that Europe should have expanded along with the United States after Do they suggest a contraction now?
Or, if one argues for an expansion now, based on cooperative arguments, was it wise for Europe to contract in the early s? We cannot have it both ways. There seem to be two main views. The expansionary-prone view wanted a matching expansion then and wants a compensating expansion now. The tough-minded view wanted restraint then and still wants it now. In both cases, the argument is ultimately predicated upon a particular view of internal conditions in Europe—pretty much as internal conditions exert the dominant influence on U.
Thus, revealed preferences confirm the growing evidence that the gains from transatlantic coordination are too small to be at the forefront of the agenda, notwithstanding summitry rhetoric. The point is simply that the European Communities EC and the United States are both fairly closed economies, so that an expansion in the EC would have to be very strong to have significant effects on the United States.
European governments appear to be obsessed with the need to continue to apply fiscal and monetary restraint the United Kingdom being a notable exception, on which more below. This is all the more surprising, given that inflation is now safely locked at low levels; employment, although declining, remained at record high levels outside the United Kingdom; and growth remains slow in comparison with the EC average of 4. One argument for continuing restraint is that budget deficits in Europe are at least as high as in the United States 4.
In this view, any expansion would be inflationary. These arguments cannot be dismissed lightly. Until they are, calls for European action based on international cooperation are unlikely to be heeded. Evidence, however, has begun to accumulate that extreme conclusions are unwarranted.
Various studies seem to indicate that most European countries suffer from a mixture of supply-side constraints and somewhat subdued final demand. A reasonable position, given what we know, is that some demand expansion is possible, would reduce unemployment without seriously re-igniting inflation, and would help with the U.
Of course, what is true for Europe as a whole is not true for each country. Either of the two arguments for no European action may be of more relevance to some countries than to others. In particular, the need for budgetary austerity is overriding in such highly indebted countries as Belgium, Italy, and Ireland.
It is hard to take it seriously, however, for the largest European countries on this point and what follows, see Dreze and others The conclusion is that we ought to differentiate among European countries.
Given the relatively high degree of economic integration within Europe, coordination becomes a crucial issue, should any serious change in the policy mix be considered.
This contrasts with the low degree of interdependence between Europe and the United States. The problem, then, is not coordination between the United States and Europe: both sides could benefit from an expansion of demand in Europe. The Federal Republic of Germany could alleviate the U.
As the center country of a de facto asymmetric EMS, 5 it would then allow other European countries to adopt a less restrictive stance as well. Indeed, experience has shown that even the larger EMS countries, like France, cannot act on their own, and Italy is quite constrained by its budgetary situation. But Germany shows no sign of moving away from its near-zero inflation target and from a rather strict budgetary orthodoxy. Meanwhile, other countries are certainly not willing to threaten the smooth functioning of the EMS for the sake of contributing to better worldwide balances, unless, of course, another stock market disaster demonstrates that economic independence may be a serious threat.
Makin , John H. Sachs Jeffrey D. Chapter 2 contains a specific model that underlies much of the general discussion presented here.
Some writers have interpreted Black Monday as the happy bursting of a bubble. With hindsight, that explanation is not quite convincing. In Japan, where some expansionary moves have been accomplished, the fall in stock prices was relatively mild. Inflation was then a main target, and the dollar appreciation was perceived as exported inflation with a strong beggar-thy-neighbor flavor.
As a result, the European monetary-fiscal mix was probably tightened up further some econometric evidence is presented in Wyplosz The asymmetry argument is developed in Giavazzi and Giovannini Competitiveness index 1. All Rights Reserved. Topics Business and Economics. Banks and Banking. Corporate Finance. Corporate Governance. Corporate Taxation. Economic Development. Economic Theory. Economics: General. Environmental Economics. Exports and Imports.
Finance: General. Financial Risk Management. Foreign Exchange. Industries: Automobile. Industries: Energy. Industries: Fashion and Textile. Industries: Financial Services.
Industries: Food. Industries: General. Industries: Hospital,Travel and Tourism. Industries: Information Technololgy. Industries: Manufacturing. Industries: Service. How could we reform the estate tax? What are the options for taxing wealth transfers? What is an inheritance tax? Payroll Taxes What are the major federal payroll taxes, and how much money do they raise? What is the unemployment insurance trust fund, and how is it financed?
What are the Social Security trust funds, and how are they financed? Are the Social Security trust funds real? What is the Medicare trust fund, and how is it financed? Excise Taxes What are the major federal excise taxes, and how much money do they raise? What is the Highway Trust Fund, and how is it financed? Energy and Environmental Taxes What tax incentives encourage energy production from fossil fuels?
What tax incentives encourage alternatives to fossil fuels? What is a carbon tax? Business Taxes How does the corporate income tax work? What are pass-through businesses? How are pass-through businesses taxed? Is corporate income double-taxed? Tax Incentives for Economic Development What is the new markets tax credit, and how does it work? What are Opportunity Zones and how do they work? Taxes and Multinational Corporations How does the current system of international taxation work? What are the consequences of the new US international tax system?
How does the tax system affect US competitiveness? How would formulary apportionment work? What are inversions, and how will TCJA affect them? What is a territorial tax and does the United States have one now? What is the TCJA repatriation tax and how does it work? What is the TCJA base erosion and anti-abuse tax and how does it work? What is global intangible low-taxed income and how is it taxed under the TCJA?
What is foreign-derived intangible income and how is it taxed under the TCJA? Comprehensive Tax Reform What is comprehensive tax reform? What are the major options for comprehensive tax reform? Broad-Based Income Tax What is a broad-based income tax? What would and would not be taxed under a broad-based income tax? What would the tax rate be under a broad-based income tax? National Retail Sales Tax What is a national retail sales tax?
What would and would not be taxed under a national retail sales tax? What would the tax rate be under a national retail sales tax? What is the difference between a tax-exclusive and tax-inclusive sales tax rate?
Who bears the burden of a national retail sales tax? Would tax evasion and avoidance be a significant problem for a national retail sales tax? What would be the effect of a national retail sales tax on economic growth? What transition rules would be needed for a national retail sales tax? Would a national retail sales tax simplify the tax code?
What can state and local sales taxes tell us about a national retail sales tax? What is the experience of other countries with national retail sales taxes? How would a VAT be collected? What would and would not be taxed under a VAT? What would the tax rate be under a VAT? What is the difference between zero rating and exempting a good in the VAT? Who would bear the burden of a VAT? Is the VAT a money machine? How would small businesses be treated under a VAT? What is the Canadian experience with a VAT?
Why is the VAT administratively superior to a retail sales tax? What is the history of the VAT? How are different consumption taxes related? Other Comprehensive Tax Reforms What is the flat tax? What is the X-tax?
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