Helpful Hint Fiscal Policy and the AS-AD Model In this Helpful Hint, we analyze the effects of a change in fiscal policy using the AS-AD model. In doing so, it is useful to consider a specific example. Let's say that the government increases government spending (G). (At the same time, we are providing you with the logic necessary to analyze a decrease in G, an increase in taxes (T), or a decrease in T. As an exercise, you should work through the effects of one of these alternative policies when you finish reading this Hint.) Short-Run Effects of Expansionary Fiscal Policy Government spending is a component of aggregate demand, so the most easily recognizable effect of an increase in government spending is a direct increase in aggregate demand. In fact, if this were the only effect, we would be able to say that an increase in government spending of $1 billion causes an increase in aggregate demand of $1 billion. However, an increase in G affects aggregate demand by changing C, I, and NX as well. These indirect effects work through two channels:! the increase in aggregate quantity demanded (Y) which results directly from the increase in G, and! the increase in the real interest rate (r) which results from the increase in G. How does an increase in G raise r? Well, the direct increase in Y causes an increase in nominal income (PY) which causes the money demand curve to shift right. This increases the nominal interest rate (i), as shown in the following diagram, and thus increases the real interest rate (r) as well.
Money Demand Increases in Response to An Increase in G Thus an increase in government spending raises both Y and r in the short run. These short-run changes affect each of the other components of aggregate demand as follows: 1) Consumption demand rises because income is higher, but falls because interest rates are higher. Since consumption demand is generally less sensitive to interest rates than to income, on net, consumption demand will rise. 2) Investment demand rises in response to higher Y, but falls in response to higher r. If the economy has a lot of unemployed resources, then the positive effect of a greater demand for goods (Y) may be larger than the negative effect of more expensive investment funds (r). In general, though, we'll assume that investment demand will fall, given that empirical evidence show investment being highly sensitive to changes in interest rates. 3) Net export demand falls. First, a higher level of Y leads to a higher demand for imports. This is likely to be a very small effect, even in the short run. More importantly, the increase in r will make dollar denominated assets more attractive to U.S. and foreign investors. This will drive up the exchange value of the dollar. The higher dollar will encourage imports and discourage exports, leading to a decrease in net export demand. Now, we have all of the pieces we need to see how an increase in G changes aggregate demand in the short run. The increase in Y due to greater government spending causes an increase in two components of AD; the increase in r has a dampening effect on all components. (These dampening effects are called "crowding out.") We know there is an increase in G, a probable increase in C, a probable decrease in I, and a decrease in NX. The combined effect is that the aggregate quantity demanded increases at every price level when government spending increases: the AD curve shifts to the right. (How do we know that the expansionary effects outweigh the offsetting contractionary effects? Because the offsetting effects only occur because the interest rate rises, and that only occurs because Y is larger. If Y did not rise, there would be no increase in the interest rate and no offsetting effects at all.)
The short run effects of an increase in G are illustrated in the following AS-AD diagram, where AD shifts from AD 0 to AD 1. The Short-Run Effects of An Increase in G The economy moves along the SRAS curve from the initial long-run equilibrium, point A, to the new short-run equilibrium, point B. What happens is that the increase in aggregate demand causes some firms to raise their prices. Other firms have sticky prices and are prepared to raise output in the short run without raising prices. Thus, the short-run equilibrium level of output is higher than the initial level of output, and there is an inflationary gap. Employment and prices are also higher in the new equilibrium. The Transition from the Short Run to the Long Run Faced with higher demand, all firms will want to raise prices eventually. As time passes contracts are renegotiated and new menus are printed, prices and wages will rise. Each time prices and wages rise the SRAS curve shifts up. The process continues until the quantity of goods demanded is the same as it was initially. This is the point at which the SRAS curve intersects the LRAS and the new AD curve at the same point.
The Long Run The Transition to the New Long-Run Equilibrium The new long-run equilibrium is point C. At this point, output is back at its potential level and unemployment is back at the natural rate. The only difference from the original long-run equilibrium is that the new level of prices is higher. Looking only at the AS/AD diagram, you will notice that the results of expansionary fiscal policy are like the results of expansionary monetary policy. In the short run output is higher, but in the long run output returns to its initial level. However, a permanent increase in G causes the real interest rate to be permanently higher. We can understand this result by looking closely at the money market again. In the long run, an increase in G results in the same level of output and higher prices, so nominal income is higher. Higher nominal income causes money demand to be higher at every price level. This means that in the long run, the money demand curve ends up to the right of its initial level.
An Increase in G Results in Permanently Higher Money Demand Thus, nominal interest rates are higher in the long run. And, although there is a one-time change in the price level, there is no change in the rate of inflation. This means that the increase in G causes a permanent increase in the real interest rate. How does this increase in real interest rates affect the economy? Recall that in the first section of this Helpful Hint, we showed how the components of aggregate demand were affected by the short-run increase in output and the subsequent rise in the real interest rate. In the long run, the effects of an increase in output go away, but the effects of the higher real interest rate remain. Specifically: 1) Consumption demand is lower. 2) Investment demand is lower. 3) Net export demand is lower. Let's examine net exports more closely. When the real interest rate in the U.S. rises, foreigners now want to invest more in the U.S. because the return is higher. (Similarly, Americans also want to invest more of their assets in the U.S.) Thus, the dollar rises in value in response to the increased demand. This rise in value is reflected by an appreciation of the dollar, or an increase in the exchange rate. When the dollar has appreciated, U.S. exports are now more expensive abroad. In order to purchase the same $10,000 car, foreigners now have to give up more of their own money to get the $10,000. As a result, U.S. exports fall. Similarly, the higher exchange rate makes imports cheaper for Americans, so imports rise. The result is that the exchange rate is higher and the quantity of net exports demanded is lower. Thus, a permanent increase in G results in a lower current account balance. This is why economists sometimes speak of "twin deficits." What they mean is that a budget deficit (caused by expansionary fiscal policy) can cause a current account deficit through the linkages explained above.
This story holds both in the short run and over longer periods such as a decade, which is usually long enough to be considered "long run." However, a country can not continue to run trade deficits in the very long run. Eventually, a debtor country will have to pay other countries back with goods and services, which implies that it will have to run trade surpluses. Thus, the negative relationship between fiscal policy and net exports exists in the medium to long run, but not in the very long run. So, we see that although an increase in G causes no increase in Y in the long run, it changes the composition of output. Specifically, the increase in G induces an increase in the real interest rate which causes consumption demand, investment demand, and net export demand to fall. It is the fall in these three components of aggregate demand that makes it possible for G (another component of AD) to permanently rise while Y remains unchanged in the long run. Monetary Policy Revisited For comparison's sake, let's consider what happens to the composition of output in the long run in the case of expansionary monetary policy. It does not change. Recall that it is the rise in the real interest rate that drives the change in the composition of output in the case of expansionary fiscal policy. When the Fed undertakes a one-time expansion of the money supply, the interest rate is unchanged in the long run. (By one-time expansion we mean that the money supply remains permanently larger but does not continue to increase. Linking together these one-time increases with a situation of ongoing increases is a topic for intermediate macroeconomics, however, so we won't pursue it here.) Expansionary monetary policy causes the M S curve to shift to the right. It also leads to higher prices and higher nominal income in the long run. This means that money demand increases at every nominal interest rate, so the M D curve shifts to the right. Long-Run Effects of Expansionary Monetary Policy
The combined effect of these two events is that interest rates don't rise in the long run in the case of a one-time expansion of the money supply, so the long-run composition of output doesn't change. (On the other hand, continuing expansion of the money supply leads to higher inflation and thus higher expected inflation and nominal interest rates. Once again, you'll learn more about this in your next macro course.)