"Might fiscal policy fail to increase aggregate demand?
Yes, it might fail.
Economists ought not be confident enough in our knowledge of how the economy works to say they are certain that a temporary increase in government spending will definitely increase aggregate demand. We just aren't that good (as if that needed saying).
Here is one reason why it might fail. I think it is the least implausible reason why fiscal policy might fail.
A temporary increase in government spending, financed by borrowing, will increase the future level of the government debt, and increase expected future taxes.
Taxes are typically not lump-sum. Most taxes depend on income; the more income you earn, the more tax you pay. Much of our income comes from investment, in physical and human capital. Higher expected future tax rates will reduce the expected future return to current investment, and will reduce current demand for investment.
(This effect on investment is in addition to any effect that future taxes might have on permanent disposable income and current consumption, which by itself should not fully offset the increased government spending.)
The magnitude of this effect is an empirical question. It depends on the elasticity of investment with respect to future returns, and on the exact nature of the future tax increases that people expect. If investment demand were elastic enough, and the expected future taxes distorting enough, it would be possible for a temporary increase in government spending to cause investment to fall by more than government spending increased, so that aggregate demand would fall. An increase in government spending would cause the IS curve to shift left.
I do not know the answer to that empirical question. Nor does anyone else know the answer to that question with certainty. We can only rely on past experience, hope that we have interpreted past experience correctly, and hope that the lessons of the past apply to the present.
This might or might not be what William Poole was talking about. It is more likely that he was talking about something like this than talking about a vertical LM curve. He did mention higher future taxes and tax incentives for investment; he did not mention interest rates.
I draw three lessons:
1. We need to be careful how we interpret people; especially those with whom we disagree. We might learn more if we apply the Principle of Charity.
2. Our preferred policies might fail for reasons we might not have thought of. Critics might think of something we haven't thought of. "Who could have known?" has been heard too often recently.
3. It would be prudent to try to design fiscal policies to minimise the chances that they might fail for all reasons, just in case the critics are partly right. For example, government spending on investments that increase future income would be especially desirable in the light of this critique, because they would be less likely to require future increases in tax rates.
Nick, Posted by: Don the libertarian Democrat |
"OK. Let's see if I can answer all this at once.