"Life Cycle" Hypothesis of Saving: Aggregate ... - Arabictrader.com

356 Miscellanea
VI.5 The Role of Fiscal Policy
So far in our analysis we have ignored the role of public expenditures and taxes,
because we have not allowed for the existence of a public sector. Once we take
into account the government, private saving is no longer equal to private investment,
but to investment plus public deficit. This generalization can be readily
accommodated by our figure 15.4, by simply replacing the 45o line of Quadrant
III, with another, which is above it by the deficit. If the deficit is a constant independent
of any other variable (a case convenient for exposition, though not very
realistic) the new curve will be parallel to the old one. Consequently, to any given
r and corresponding I there will correspond a higher saving and hence income.
But this means that the deficit will have the effect of shifting up the IS curve by
an amount equal to the deficit times the multiplier.
But what happens to X is finally dependent on the response of the monetary
authority. In the elementary “text book” version, the Central Bank (CB) is
(implicitly) assumed not to let the deficit affect the interest rate; then IS rises by
the deficit times the multiplier; but since this raises the demand for money, the
CB must be prepared to expand the money supply, to match so that the intersection
of the new money demand and supply curves correspond to X¯ (and the initial
r) (all this is not shown in the graph which is already over clogged, but is easily
constructed!). At the other extreme, suppose CB holds M s unchanged, then X
rises by a fraction of the deficit times the multiplier because the increased demand
for money, with an unchanged supply, raises the interest rate, crowding out some
I and offsetting a portion of the deficit, (the deficit could also displace some I as
a substitute).
This result is important in that it implies that fiscal policy offers an alternative
tool to control employment. To illustrate, suppose the economy finds itself in
the underemployment equilibrium, a*. Then, by creating an appropriate deficit
through increased expenditure (or lower taxes), and with an accommodating
monetary policy can be shifted until X* corresponds with X¯. This opportunity
could, obviously, be also exploited to counter a Liquidity Trap.
The Keynesian recognition of the possible employment effects of Fiscal Policy
has given origin to a widely held view that the essence of Keynes is the advocacy
of fiscal deficits. While this association might have had some basis in the
early years of the General Theory in the immediate aftermath of the Great Depression,
it is totally false at present. In particular my view, which I believe would
be broadly acceptable to those who understand the fundamental Keynesian
message, is that employment stabilization should be primarily the responsibility
of monetary policies, except for automatic fiscal anti-cyclical stabilizers, while