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A Balanced Budget Rule, Crowding Out, and Where the Warring Schools Converge
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From the course by University of California, Irvine
The Power of Macroeconomics: Economic Principles in the Real World
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University of California, Irvine
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From the lesson
The Warring Schools of Macroeconomics
Meet the Instructors
Dr. Peter NavarroProfessor
Paul Merage School of Business
A
second rule that is often debated is that of a balanced budget rule.
In this regard, Monetarists and New Classical
economists question the effectiveness of fiscal policy.
And at the extreme, a few of these economists favor a
Constitutional amendment to require the Federal
government to annually balance its budget.
Still others simply suggest that the
government be passive in its fiscal policy,
meaning that it should not intentionally create budget deficits or surpluses.
This is because in this view, deficits and surpluses caused by recession or
inflationary expansion will eventually correct themselves as
the economy self-corrects to its full-employment output.
So do Keynesian based mainstream economists respond
to the calls by monetarists and new classical
economists for a monetary rule, and a balanced budget requirement?
In supporting discretionary monetary policy, Keynesian based economists argue
that the rationale for a monetary rule is flawed.
While there is indeed a close relationship between the money supply and nominal GDP
over long periods, in shorter periods, this relationship breaks down.
This argument goes back to our earlier argument about the
stability of the velocity of money alleged by the monitorists.
Arguing that velocity is variable, both cyclically, and over time.
The Keynesian based economists contend that a constant annual rate of
increase in the money supply need
not eliminate fluctuations in aggregate demand.
In terms of the equation of exchange,
a steady rise in M does not guarantee a steady
expansion of aggregate demand, because the velocity V can change.
As for the use of discretionary fiscal policy, the
major area of debate revolves around one of the
most important concepts in macroeconomics, the so called crowding
out of private sector investment by expansionary fiscal policy.
Crowding out is the offsetting effect on private expenditures caused
by the government sale of bonds to finance expansionary fiscal policy.
Here's how it may happen.
When the Federal government borrows money to
finance a budget deficit, the U.S. treasury sells
IOU's in the form of bonds or
treasury bills directly to the private capital markets.
And uses the proceeds of the sales
to finance the deficit.
Note that in this case, the Federal Reserve is out of the loop.
Note also that the U.S. Treasury is competing directly
in the capital markets with private corporations, which may also
be seeking to sell bonds and stocks in order
to raise capital to invest in new plant and equipment.
In order to compete for these scarce investment dollars, the treasury typically
must raise the interest rate it is offering in order to attract enough funds.
This is because, in this case, running a deficit is largely a zero sum game.
The money used to finance the deficit is money that would otherwise
have been borrowed and spent by
corporations and businesses on private investment.
In this case, deficit spending by the government is said to crowd
out private investment.
This crowding out effect is illustrated by these two figures.
On the lefthand figure, an increase in investment demand by the
government shifts the investment demand curve from id one to id two.
This raises the interest rate and reduces private
investment as is made clear by the right-hand figure.
Note that in this figure,
if the economy starts at point a and moves to point
b, crowding out will be equal to h one minus h two.
But if the economy starts at point C in a
recession and moves to point B, crowding out need not occur.
Now, what is perhaps most interesting about the crowding out
effect within the context of our warring schools of macroeconomics
is this.
Monetarists believe that substantial crowding out
is associated with discretionary expansionary fiscal policy.
And therefore conclude, it shouldn't be used because it is ineffective.
On the other hand, while Keynesian based
economist recognized the possibility of crowding out, they
do not think it is a major problem
when business borrowing is depressed, as is usually
the case in a recession.
Therefore, activist expansionary fiscal policy is appropriate.
As for a balanced budget rule,
Keynesian based mainstream economists are likewise opposed.
They argue the tax revenues fall sharply during
recessions, and rise briskly during periods of demand-pull inflation.
Therefore, a law or constitutional amendment mandating
an annually-balanced budget would require the government
to increase tax rates and reduce government
spending during recession, and reduce tax rates
and increase government spending during economic booms.
Clearly, the first set of actions would worsen recession.
While the second set would fuel inflation.
Now let's turn to the supply side perspective, on the
issue of rules versus discretion.
Supply siders argue that marginal tax rates and government regulations, must
be reduced in order to get more output, without added inflation.
Thus, supply siders favor discretionary policy actions much like Keynesians do.
However, very often, the focus of such actions is classically oriented,
in that the actions advocated seek to reduce or undo
the negative effects of earlier government regulations or tax policies.
From our discussion so far, we have seen that there
are fundamental areas of disagreement
between the warring schools of macroeconomics.
Nonetheless, despite these many areas of disagreement,
there are areas when their thoughts have converged.
For example, most Keynesian based economists now
agree with the monetarists that, money matters.
And that excessive growth of the money supply
is the major cause of long-lasting rapid inflation.
Keynesian based economists also agree with the
rational expectations proponents, that expectations are, indeed, important.
In this regard, if government can create
expectations of price stability, full employment, and
economic growth, households and firms will tend to act in ways to make that happen.
Finally,
Keynesians concur with the supply siders that government
needs to focus on policies to increase economic growth.
Bottom line is that thanks to ongoing challenges to the
conventional macroeconomics wisdom, macroeconomics continues
to be an evolving policy science.
In the next lecture, we return to a more narrow
focus as we examine the important issue of economic growth.
In the mean time, please remember that
economics is not something to be memorized,
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but rather something to conceptualize. As you study it, think about it too.
Your job and your business might just depend on it.
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