MSB, Chapter 15, pp. 364-383.
What can the government do to reduce business
Can the government stabilize the economy by using fiscal
and monetary policy?
Monetary policy can be implemented through changing
money supply or the rate of interest.
An expansionary monetary policy implies expanding
money supply or directly reducing the rate of interest.
A restrictive monetary policy implies reducing money
supply or directly increasing the rate of interest.
A fiscal policy may be carried out by changing the
government expenditure or by changing taxes.
An expansionary fiscal policy implies higher government
expenditure or lower taxes.
This implies a government budget deficit.
This deficit can be financed in two ways.
The first way consists in the central bank buying
government debt bonds issued by the government; in this
case the government budget deficit also implies an
increase in money supply.
The European Central Bank is forbidden in its statute from
following this route. This is not the case, for instance, with
the US Federal Reserve System (FED).
The alternative way is for savers to buy bonds issued by
the government to finance its budget deficit.
This is the only way that can be followed in the
In this case an increase in the government deficit means
that more government bonds will be issued, i.e.
additional government debt will be created.
The excess supply of government bonds will decrease
their market price and this will increase the rate of
The opposite happens when the government uses a
restrictive fiscal policy reducing its deficit by decreasing
government expenditure or increasing taxes.
A downturn in a business cycle: a negative aggregate demand
shock (fall in firms’ investment expectations) reduces real GDP
and increases unemployment.
The government may bring back the economy to its full
employment position by increasing expenditures or reducing
taxes. The central bank could achieve the same result by
expanding money supply and/or reducing the interest rate.
A negative aggregate supply shock (increase in oil price) reduces
real GDP and increases the price level (stagflation).
The government can try to support a recovery through an
expansionary fiscal policy (or the Central Bank could do the same
by reducing interest rates). The result will be a higher real GDP
but also a higher inflation.
The idea that government’s fiscal policy or monetary policy
could stabilize the business cycle has been very popular
until recently, when it started to be objected by many
One objection makes reference to the so called “automatic
The idea is that there is no need of an explicit stabilization
policy as to a significant extent government spending and
taxes respond automatically to the business cycle.
In a recession taxes tend to fall due to falling incomes and
private sector spending. Some government expenditures
such as transfers for unemployment benefits tend to rise.
As a result aggregate demand tends to automatically
increase during a recession.
A more significant objection concerns the effectiveness of
a fiscal stabilization policy, for instance of a fiscal deficit.
This kind of objection is summarized in the so called
“Ricardian equivalence principle”.
In the eighteen century English economist David Ricardo
claimed that financing government expenditure by rising
taxes or by issuing government debt would have little
impact on demand if people were forward-looking.
Suppose that in period 1 the government finances a
budget deficit by issuing debt (D):
1 1 1G T D
In period 2 the government has to repay the debt plus the
interests. This means that in period 2 the government must
have a budget surplus; the government intertemporal
budget constraint is:
2 2 1 1 1T G (1 r)D (1 r) G T
If in period 1 consumers have saved, in period 2 they can
2 2 2 1 1 1C Y T 1 r Y T C
2 2 2
1 1 1
C Y T
C Y T
1 r 1 r 1 r
Dividing both sides by (1+r), we obtain:
The present value of consumption equals the present
value of pre-tax incomes minus the present value of
2 2 1 1 1T G (1 r)D (1 r) G T implies
1 r 1 r
The present value of government spending equals the
present value of tax revenue.
2 2 2
1 1 1
C Y T
C Y T
1 r 1 r 1 r
2 2 2
1 1 1
C Y G
C Y G
1 r 1 r 1 r
The intertemporal budget constraint for households
makes no explicit reference to the fiscal deficit.
This is because lower taxes today must be compensated
by higher taxes in the future.
In this situation a budget deficit is likely to be
compensated by lower consumption and higher saving
with no real impact on aggregate demand.
2 2 2
1 1 1
C Y T
C Y T
1 r 1 r 1 r
1 r 1 r
These implications of the Ricardian equivalence are too
For example, there is no reason to believe that the
expectation of higher future taxes should necessarily
reduce the current private demand.
If the expansionary fiscal policy is successful, the
increase in future GDP will provide the basis for the
future required increase in taxes.
• that the multiplier effects of fiscal deficits are sizeable
• that the fiscal deficit is temporary, which makes less
likely that future taxes should be levied in order to
face future higher public debt.
Another objection to the effectiveness of fiscal stabilization
policy is the “crowding out effect”.
We have seen that when the government follow an
expansionary fiscal policy by increasing its deficit because
of higher expenditures or lower taxes two things can
Either the central bank finances this higher deficit by
issuing more money to buy the newly issued government
bonds corresponding to the additional public debt.
Or, when this is forbidden as in the Eurozone, savers must
buy the newly issued government bonds.
In this second case the rate of interest will increase.
When an expansionary government deficit is financed by the
Central Bank thorugh new money supply, this implies that both
the IS and the LM curves will shifts outwards.
The effect will be that of expanding the aggregate demand with
no effect on the rate of interest.
If the government expands its expenditure or cuts taxes, and
expands its budget deficit creating new government debt, only
the IS curve shifts outwards. Given money supply, the rate of
The increase of the rate of interest reduces the initial increase in
The expansionary effect
of the budget deficit is
lower than in the case
than it is when
accompanied by an
The case where expansionary fiscal policy is not
accompanied by monetary policy means that the new
created government debt to finance the government deficit
must be absorbed by the market.
In this case the rate of interest increases and this has a
negative effect on the private investment expenditure.
This means that the government expenditure, or more
generally the government deficit, “crowds out” private
The result is a lower expansionary effect on the level of
The Inflation-Output Trade-off.
Expansionary fiscal and monetary policies increase the
aggregate demand and reduce unemployment, but the
price level rises, so that they also produce inflation.
The British economist Bill Phillips found a decreasing
empirical regularity between unemployment and inflation:
the lower the unemployment, the higher inflation tended to
be; and viceversa.
This is called “Phillips curve”.
The Nobel prize winners in Economics, Edmund Phelps and
Milton Friedman, provided a formal expression for the Phillips
curve by introducing the role of expected inflation.
Suppose that in the labor market the natural rate of
unemployment prevails, with a corresponding real wage.
Suppose that expected inflation is 3%. If wages and prices
increase at the same rate as the expected inflation, real
wages will remain constant and the rate of unemployment
would remain at the natural rate.
Suppose now that prices increase by more than 3%, while
expected inflation remains at 3% so that money wages
(governed by inflation expectations) increase only by 3%.
Real wages would fall and firms would hire more workers:
the unemployment rate would fall below the natural level.
= rate of inflation
= expected rate of inflation
u = rate of unemployment
uN = natural rate of unemployment
The Phillips curve is
The Phillips curve
The Phillips curve derives from some assumption leading
wages to adjusting not as rapidly as prices.
This is because inflation expectations do not immediately
adjust to current inflation.
When the government through expansionary fiscal and
monetary policies increases the price level, money wages
increase less than the price level, and the real wages fall.
Unemployment falls as firms will demand more labor at
lower real wages.
When the government through restrictive fiscal and
monetary policies reduces the price level, money wages fall
less than the price level, and the real wages increase.
Unemployment increases as firms will demand less labor at
higher real wages.
The Phillips curve can be adjusted to take into account
Nu u x
where x represents a supply shock; for instance an
increase in the oil price.
The Phillips curve shifts:
• if the natural rate of unemployment changes;
• if the expected inflation changes;
• if there are supply shocks.
All these events characterized the development of the
advanced economies from the eighties of the last century.
From that period the relation between inflation and
unemployment does not fully and always correspond to a
Phillips curve. 25
0 2 4 6 8 10 12
Inflation and unemployment in the United States , 1980-2009
0 1 2 3 4 5 6
Inflation and unemployment in Japan, 1908-2009
In particular, there is a different Phillips curve for each level of inflation
In UK in the period between 1957 and 1997 inflation was higher that
in the period between 1856 and 1957; and so were inflation
Suppose that initially the unemployment equals its natural
(equilibrium) level, with actual and expected inflation of 2%.
0 0 2%
The government wishes to
achieve lower unemployment and
increases government spending.
Inflation moves to 4%.
Because of nominal wage
sluggishness, real wages fall and
Sooner or later inflation expectations will be revised upwards to
react to the higher inflation: the Phillips curve shifts upwards.
Higher inflation expectations
mean that wages will adjust
increases back to the natural
The new inflation rate
has increased to 4%.
The long run effect of
policy is only higher
N Nu u u u
If the government wants to keep unemployment below the natural
rate it must increase demand again. Inflation will jump to 6%.
When inflation expectations
will have adjusted to
6%, the Phillips curve shifts
Unemployment will increase
to its natural level.
But the inflation rate will
now higher: 6% instead of
If individuals adapt their inflation expectations in response
to changes in observed inflation, expansionary government
policies will have short run effects in terms of lower
unemployment, but they will eventually produce only
In the long run there is only a vertical Phillips curve: there
in no trade off between inflation and output.
The only way to reduce permanently the rate of
unemployment is to reduce the natural rate of
unemployment through supply and not through demand
The question of the way and of at which speed individual
agents adjust their inflation expectations is crucial.
Suppose initially the unemployment equals its natural (equilibrium)
level, with actual and expected inflation of 6%.
Monetary policy is tightened to reduce
inflation to 2%.
If inflation expectations are not revised
downwards, real wages increase, the
demand for labor falls, unemployment
rises and the economy goes to point B.
Eventually the private sector will adjust its inflation expectations to
2%: the Phillips curve will shift downwards.
1 1 2%
With lower inflation expectations, wages
will fall, the demand for labor will increase
and the unemployment will go back to its
The inflation will be lower but at the price
of a period of unemployment.
But suppose now that people are rational in forming their
expectations: they anticipate and believe that the
government will be successful in reducing inflation at 2%.
They immediately revise downwards their inflation
expectations when the monetary authority announces its
willingness to reduce inflation.
The Phillips curve shifts immediately downwards as there
is no need that unemployment increases to induce people
to revise their inflation expectations downwards.
1 1 2%
With rational expectations, the simple
announcement of the monetary
authority will be enough to move the
economy to point C (inflation at 2% and
natural rate of unemployment).
Rationality of expectations and
credibility of the monetary authority are
To be credible both fiscal and monetary stabilization
policies should be consistent, and particularly they should
be “time consistent”.
Suppose the Central Bank has followed an monetary policy
to lower inflation and this has succeeded in lowering
inflation expectations, shifting down the Phillips curve and
allowing the economy to be at its natural unemployment
Now suppose that after some time the government decides
to follow an expansionary fiscal policy: the unemployment
rate falls along the Phillips curve.
People should now immediately revise inflation
expectations upwards; but they may be reluctant to do
it, in presence of an inconsistent behavior from the Central
Suppose the economy starts at A with high expected and actual
Monetary policy has been successful in
lowering inflation expectations and
shifting the economy at B.
Now the government uses a fiscal policy
to move to C.
People should shift up
again; the economy
would go back to A
with a higher inflation.
They may be reluctant
to do so.
To avoid time inconsistency it has been proposed that the central
bank should always control inflation and the government always
follow a balanced-budget rule.