Lecture Notes: Fiscal Policy and Economic Shocks

Overview of Fiscal Policy

• Fiscal policy is generally effective when resources are underemployed due to an aggregate demand shock.
• There's less consensus on using fiscal policy for shifts in aggregate supply or the risks of debt-financed policies.

Aggregate Demand vs. Supply Shocks

• Aggregate demand shock:
  • Economy operates below potential.
  • Fiscal policy can help bring economy back to potential.
• Aggregate supply shock:
  • Change in potential growth rate.
  • Fiscal policy is less effective and may cause higher inflation.

Challenges of Fiscal Policy

• Timeliness, targeting, and crowding out remain issues even with supply shocks.
• More spending doesn't solve underlying problems; may lead to inflation.

Risks of Debt-Financed Fiscal Policy

• Fiscal policy is meant to smooth consumption (increase demand in bad times, pay off in good times).
• In practice, governments often increase spending in both bad and good times.
• Continuous debt growth can limit future fiscal responses:
  • Larger budget portions needed for interest payments.
  • Less flexibility in future recessions.

Dangers of Excessive National Debt

• Too much debt can lead to economic instability, especially if borrowing in foreign currencies.
• Example: Argentina's financial crisis (1999-2002):
  • Increased borrowing led to nervous investors.
  • Financial crisis led to decreased consumption and investment despite increased government spending.
  • Resulted in a default on debt with debt at 150% of GDP.
• Similar issues in countries like Thailand, Indonesia, Mexico, and Greece.

Conclusion

• There's debate over how much debt is too much.
• High debt and low government credibility can make fiscal policy harmful.
• Fiscal policy should be used wisely and selectively.