7 Feedbacks of fiscal policy on GDP

Up to this point, we have ignored in our simulations that a change in the government’s fiscal policy is likely to have effects on the level of GDP and its further development. We have pointed out several times that these effects can be extremely important and have referred to the European experience with austerity policies after the global financial crisis and the euro crisis. We now turn to such macroeconomic feedback effects by including them in a stylised form in our simulations. Before we do so, we can broadly distinguish between the short-run and the long-run effects through which a change in fiscal policy might affect the development of GDP.

Short-run effects:

In the short run, fiscal policy affects GDP mainly through its impact on aggregate demand. If the government cuts its spending on goods and services or its financial support to low-income households, this will reduce aggregate demand in the economy and, in the absence of compensating forces, will have a negative impact on GDP. Similarly, if the government increases taxes and withdraws income from households or businesses without using this income to increase public spending, this is also likely to have a negative impact on aggregate demand and reduce GDP.

Of course, one could discuss whether there are other economic forces that could offset these negative effects on aggregate demand in the short run. For example, one could argue that the government’s commitment to reduce its debt would boost confidence in the economy, especially in the corporate sector, and thus lead to higher private sector spending, especially on investment. Indeed, such alleged confidence effects have often been invoked to justify austerity measures.

However, the disastrous experience with austerity policies has shown that such potential confidence effects do not seem to be relevant, at least not in the short run. Indeed, if severe austerity policies lead to a sudden decline in aggregate demand, it is more likely that confidence in the economy will decline further, leading to additional negative effects on investment and GDP.

From a short-term perspective, it therefore seems sensible for the government to choose the timing of its fiscal policy changes carefully. If the goal is to reduce the debt ratio, the government should wait to reduce its deficit until the overall economy is in a “good” state, i.e. until other factors affecting GDP are generally prospering. In contrast, it does not seem advisable for the government to try to reduce the deficit in times of crisis.

Of course, an expansionary fiscal policy will have the opposite effects compared to the contractive case scetched above. So if the economy is in a downswing, it can make sense to increase fiscal spending, so as to stabilize or even increase GDP. Overall, such countercyclical policy can even have a positive effect on the debt-ratio.

The fiscal multiplier: The fiscal multiplier describes how much GDP rises in response to additional government spending or tax cuts (expansionary fiscal policy). Vice versa, the fiscal multiplier also tells us how much GDP shrinks in the case of decreasing government spending or tax increases (contractionary fiscal policy). The effect of the fiscal multiplier is likely to vary depending on the type of fiscal measure and the circumstances under which the measure was implemented. Sebastian Gechert offers a nice summary of the debate and research on the size of the fiscal multiplier.

Long-run effects

In addition to the short-term effects on aggregate demand, changes in governments’ fiscal policies can also affect the long-term evolution of GDP by influencing the long-term growth rate of the economy. Again, there are various arguments about the long-term effects of a change in fiscal policy. Here too, it could be argued that the government’s commitment to reduce its debt could boost domestic and foreign business confidence, which would lead to higher private sector investment, which in turn would increase the economy’s productive capacity and its potential for future growth. But again, such effects have hardly been observed in countries that have been affected by austerity measures over short or long periods of time.

In contrast, the government itself can be an important source of investment demand in the economy, and its spending can be an important source of maintaining and expanding the economy’s infrastructure. Cutting this spending can deprive the economy of important sources of growth-enhancing economic activity. Non-investment spending by the government, e.g. on education and health, can also increase the potential output and potential growth rate of the economy. Finally, as an important source of aggregate demand, the government could relieve firms of uncertainty about the profitability of investment projects, which could also increase the private sector’s willingness to invest and thus potential growth. Thus, if the government deficit is used for growth-enhancing measures, rising government debt can have a growth-enhancing effect beyond the short term.

A Golden Rule for public investment? Estimates of multipliers show that the multiplier for public investment is particularly high, especially during economic downturns and recessions. Moreover, many studies also identify public investment as a growth amplifier in the long run, which is why neglecting public investment would most likely lower an economy’s growth potential and thus prove to be a risk for future generations. The Golden Rule for public investment in the traditional finance literature therefore allows public investment to be financed through budget deficits while promoting intergenerational fairness and economic growth. Proponents of the golden rule argue that public investment increases the stock of public and/or social capital and creates growth for the benefit of future generations. From this perspective, future generations are justified in contributing to the financing of these investments through debt service.

Another relevant factor for the growth rate of an economy that goes beyond the short run is the timing of changes in fiscal policy. If the government pursues counter-cyclical fiscal policies to stabilise GDP growth in times of severe crisis, this can mitigate the potential negative effects of the crisis on an economy’s long-term growth potential (so-called hysteresis effects).

Real vs. nominal effects: When we talk about the impact of fiscal policy on GDP, we can distinguish between real and nominal effects. A real effect would mean that the level of economic activity, measured in terms of real GDP, is affected. In contrast, a nominal effect could result from a change in economic activity and/or the price level (inflation). When we talk about GDP effects of fiscal policy, we usually mean real effects. However, fiscal policy can also influence the inflation rate, since the level of inflation depends, among other things, on the development of economic activity. The real GDP effects triggered by fiscal policy measures can therefore also have an impact on inflation.

Our brief account above shows that the impact of fiscal policy on GDP and its growth rate is controversial. On the one hand, a lower public debt burden and government commitment to deleveraging could boost business confidence and stimulate growth. On the other hand, debt could increase even further if a tightened belt constantly hampers aggregate demand and public investment, thus slowing growth (“debt paradox”).

In the next application, you can enter the direction and strength of the short- and long-term effects of fiscal policy on nominal GDP yourself and observe the consequences for the debt ratio.

Simple feedback effects of fiscal policy on GDP: In this app, you can insert short- and long-term effects of fiscal policy on nominal GDP and observe the consequences for the debt ratio.

Important assumptions and limitations: For now, the macroeconomic feedbacks of fiscal policy are assumed to have an overall effect on nominal GDP, which means that real GDP effects and inflation effects are implicitly added together. We will change this simplification in the next section. There are also no cyclical feedback effects on government revenue and expenditure.

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Simple feedback effects of fiscal policy on GDP, with country data: In this app, you can repeat the previous exercise with connection to actual data.

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The debate on the growth effects of the public debt ratio: Above we have discussed the potential effects of a change in the government’s fiscal policy on GDP in the form of a change in the deficit. Distinct from this is the debate about the impact of the level of the debt-to-GDP ratio as such. In 2010, two well-known economists published an empirical paper on the negative impact of a debt-to-GDP ratio above 90% on real economic growth. The paper had a major impact on the economic policy debate and was used as an argument by the proponents of austerity policies.

Unfortunately, it later turned out that the result of the study was based on an error in the authors’ spreadsheet and on some unconventional methodological choices. Other researchers later showed that these negative effects of a debt-to-GDP ratio of over 90% could not be observed when the study was corrected.

Phillip Heimberger provides a nice summary of this controversy and the empirical research on the relationship between economic growth and government debt.9