Lecture on Fiscal Policy and Aggregate Shocks

Key Concepts

Fiscal Policy

• Fiscal policy is useful when resources are underemployed due to an aggregate demand shock.
• Less agreement on its use for aggregate supply shocks.
• More effective when the economy operates below its potential.
• Fiscal policy challenges include timeliness, targeting, and crowding out.

Aggregate Demand vs. Aggregate Supply Shocks

• Aggregate Demand Shock:
  • Economy operates below potential.
  • Fiscal policy can boost economy back to potential.
• Aggregate Supply Shock:
  • Economy's potential growth rate falls.
  • Fiscal policy has limited power and can lead to inflation.

Potential Dangers of Debt-Financed Fiscal Policy

• Use of debt-financed fiscal policy for national consumption smoothing:
  • Increase demand in bad times, pay off in good times.
  • In practice, spending occurs in both bad and good times, leading to debt accumulation.
• Growing debt increases interest payments, limiting future fiscal policy options.

Risks of Excessive National Debt

• Excessive debt can lead to uncertainty, risk, and economic collapse.
• Example: Argentina (1999-2002) financial crisis:
  • Government spending increased, but investor confidence fell.
  • Resulted in decreased GDP and default on payments.
  • Similar cases in Thailand, Indonesia, Mexico, Greece.

Conclusion

• Fiscal policy is useful but must be applied wisely.
• The level of acceptable debt is debated, but high debt with low credibility harms fiscal effectiveness.