Fiscal Shocks: Impact, Adjustment Path and Long-Run Equilibrium
What is Fiscal Policy?
Fiscal policy is the instrument by which the government of a country adjusts its spending levels (expenditure) and tax rates (income) to monitor and influence the country’s economy. It is the sister strategy to monetary policy through which a central bank influences a nation’s money supply.
Instruments of Fiscal Policy
The major instruments of fiscal policy are as follows:
- Budget
- Taxation
- Public Works
- Public Expenditure
- Public Debt.
Forms of Fiscal Policy
Fiscal policy can have two forms- a fiscal expansion and a fiscal contraction.
A fiscal expansion is generally defined as an increase in economic spending owing to actions taken by the government (for example- in the form of tax cuts, rebates and increased government spending).
A fiscal contraction would be the opposite, in which there would be a decrease in economic spending due to the actions of the government, like-increase in taxes or reduced government expenditure.
Fiscal Shock
A fiscal shock is the activity of the government of a country that results in the shift of the IS curve. This shock can be positive (a rightward shift in the IS curve) or negative (a leftward shift in IS curve).
Effects of a Fiscal Shock in the Short and Medium Run: The Adjustment Path
Let’s take the case of a negative fiscal shock.
The fiscal contraction is assumed to happen due to a decrease in government spending. Before the change in government spending, the aggregate demand in the economy is represented by the AD curve. The aggregate supply is represented by the AS curve. The aggregate demand and aggregate supply curve intersect at point A, at which the equilibrium output is Yn, which is the natural level of output, and the price level is given by P, which is equal to the expected price level.
Now, the government has decided to decrease its spending, G.
Recall that, Aggregate demand equation is given by,
Y = Y {M/P, G, T),
where G stands for government spending and T for taxes, and M/P stands for real money stock.
From the above equation, it can be seen that a decrease in government spending would reduce output in the short run. The aggregate demand curve shifts to the left from AD to AD’. For a given level of price, output is lower. In the short run, the equilibrium moves from A to A’, output decreases from Yn to Y’ and the price level decreases from P to P’, and interest rates also decreases.
Here in the short run, we cannot tell whether or not investment decreases or increases. This is because lower output decreases investments, but lower interest rate increases investments.
Over time, the adjustment of price expectations comes into play. Aggregate supply curve which is given by the equation,
P = Pe (1+μ) F (1-Y/L, z),
where Pe is the expected price level, μ is the markup, z is the catchall variable for all other factors that affect wage determination and in turn, price, L is the labour force, shifts right. This happens because the output in the short run is less than the natural level of output. The price level is lower than what the wage setters expected.
They, therefore, revise their expectations, which causes the aggregate supply curve to shift right. The economy moves down the new AD curve, i.e. AD’. The adjustment process continues till the output returns to the natural level of output. The final equilibrium happens at the intersection of the AS curve represented by AS’’ and the AD’ curve at point A’’, where the output is the same as Yn and the price level is at P’’. P’’ is lower than both P and P’.
Here in the medium run, we can tell the effect of decreased government spending on the investment level. This can be understood with the help of the IS curve equation, which is given by the following expression-
Yn = C (Yn – T) + I (Yn, i) + G
In the medium run, the output is the same as before. As output and tax rates are unchanged, therefore the consumption is also the same as before. Now with reduced government expenditure, to maintain the equation, investment has to increase by the same level as the decrease in government spending. Put another way, in the medium run, a reduction in government spending unambiguously leads to a decrease in the interest rate and an increase in investment.
The above discussion shows that in the short run, a negative fiscal shock/ fiscal contraction leads to a decrease in the output, a decrease in the interest rate and a decrease in the price level. But over time, the effect of the negative fiscal shock on output disappears and the interest rate and the price level decrease further.
Similarities and Differences in the Effects of Monetary and Fiscal Shocks
In the short run, both types of shocks affect all three variables, namely –price level, interest rates and output. Like a monetary shock (for example, an increase in the nominal money supply), a fiscal shock (for example, a reduction in government spending) also does not affect the output forever and eventually, the output returns to its natural level of output in both the cases in the medium run.
But there is an important difference between the effects of these two shocks on the interest rate in the medium run. While the interest rate comes back to its original level in case of a monetary shock, this is not the case with a fiscal shock.
The Long-Run Equilibrium
The output, in the long run, depends upon two relations between output and capital-
- The amount of capital determines the amount of output being produced.
- The amount of output determines the amount of savings and, in turn, the amount of capital being accumulated over time.
The First Relation– Output per worker is a function of capital per worker, under assumptions of constant population size, constant participation and unemployment rate and a situation of no technological progress, can be written as-
Yt /N = f (Kt/N) …………… eq(i)
The Second Relation can be explained in two steps-
Step 1. Deriving the relation between output and investment, This relation is derived under three assumptions-
- The economy is closed, which implies investment (I) is equal to the sum of private(S) and public saving (T-G), i.e. I = S + (T-G)
- That public savings are zero, so we can focus on the behaviour of private savings.
- Private saving is proportional to income, i.e. S = s Y (where s is the savings rate)
Combining these three assumptions, we can write the following equation,
I = S = sY or It = sYt …………… eq(ii)
i.e. investment is proportional to output.
Step 2. Deriving the relation between investment and capital accumulation
Assume that capital depreciates at the rate of 𝛿 per year, then the evolution of capital stock from year t to t+1 can be written as-
Kt+1/N = (1- ) Kt/N + It/N …………… eq(iii)
i.e. capital per worker at the beginning of year t+1 is equal to capital per worker at the beginning of year t adjusted for depreciation plus investment per worker during the year t.
By expanding and rearranging the terms in eq(iii), we get-
Kt+1/N – Kt/N = It/N – 𝛿Kt/N …………… eq(iv)
And if we put the value of investment from eq(ii) in eq(iv), we get-
Kt+1/N – Kt/N = sYt/N – 𝛿Kt/N …………… eq(v)
i.e. change in capital stock per worker is the difference between savings per worker and depreciation per worker.
Dynamics of Capital and Output
By putting the value of output per worker from eq(i) in eq(v), we get-
Kt+1/N – Kt/N = s f (Kt/N) – 𝛿Kt/N …………… eq(vi)
If investment per worker exceeds depreciation per worker, capital per worker increases, and when investment per worker is less than depreciation per worker, the capital per worker decreases.
It is only when investment per worker is equal to depreciation per worker that the capital. These levels of capital per worker and output per worker are the long-run equilibrium levels and are given by K*/N and (Y*/N), respectively. Thus it can be said that in the long run, growth in output per worker is zero because the output is not changing as the capital is not changing.
Steady-State Capital and Output
The state in which output per worker and capital per worker is no longer changing is called the steady state of the economy. Putting the left side of the eq(vi)= 0, i.e. change in the capital as zero, we get the value of steady state capital as,
s f (K*t/N) = 𝛿K*t/N …………… eq(vii)
i.e. the steady-state value of capital per worker is such that the amount of savings per worker is just sufficient to cover the depreciation of capital stock per worker.
The Savings Rate and Output
So answering the question, “How savings affect the growth of output per worker?”
- The savings rate has no effect on the long-run growth rate of output per worker, which is equal to zero. This is because, in the long run, the economy converges to a constant level of output per worker.
- But the savings rate does determine the level of output per worker in the long run. The countries that have a higher saving rate achieve a higher output per worker in the long run.
Thus, an increase in the saving rate will lead to higher output per worker for some time but not forever.
Conclusion
The fiscal policy is an important instrument in the hands of the government of a country to regulate the economy. Through its fiscal policy, it can affect the aggregate demand, interest rates, and output and price levels in the economy. The fiscal shocks affect the output, interest rate and the price level in the short run while in the medium run, they affect only the price level and interest rates, keeping the output as before, at the natural level of employment.