Fiscal Policy and Crowding Out

Effective fiscal policy has to be timely, targeted, and temporary. But how the central bank, businesses, and consumers respond to fiscal policy also plays a role in how effective it is.

When expansionary fiscal policy is enacted, what happens to the aggregate demand curve? It shifts out with the goal of increasing real GDP growth in the short run. But inflation also increases. Can you think of how a central bank might respond to higher inflation? Yep, they might contract the money supply through monetary policy.

So one way that fiscal policy can be offset is by the actions of a central bank. Now let’s think about how businesses and consumers might respond to expansionary fiscal policy.

If the government has increased its spending through borrowing, interest rates in the loanable funds market tend to be higher for consumers. If you’re a business owner, you might think twice about investments that would require a loan. Decreased investment has a negative effect on overall real GDP growth, partially offsetting fiscal policy.

What if the government uses tax cuts in its stimulus plan? You may decide to not spend that extra money, thinking that a tax cut today might be matched by a tax increase in the future. That’s good planning! If enough people think this way and save their tax cuts, this will completely crowd out the fiscal multiplier.

In reality, this particular scenario is unlikely. Think about it – do you incorporate your future (and unknown) tax burden into your financial decisions today? Probably not. Most people tend to not be quite that future-oriented. But it’s not safe to assume that everyone will just spend all of their tax cuts either.

As you can see, there are quite a few unknowns when it comes to how a stimulus will be received. A thorough understanding of the models is crucial for successful fiscal policy, as is context for the economic situation in which they will be implemented.