5.2 Fiscal policy, monetary policy and the role of expectations and backloading

Fiscal policy
As has been described in more detail above, with given expectations about the future, a change in the current interest rate leads only to a small change in private demand. The multiplier is small. In the graph, the current real interest rate r is plotted on the vertical axis, the current income Y0 on the horizontal axis. The equilibrium is at the intersection Eq0 of the IS- and LM curve. After looking at the steeper IS curve with expectations and the movement on the curve caused by a change in the real interest rate, let us now analyze shifts of the IS curve caused by changes of other variables. For example, an increase in current government expenditure G causes the IS curve to shift to the right. Here, the same processes take place as in the IS curve without expectations - the demand for goods and income increase.
If the expected future income Y , rises, the IS curve also shifts to the right, as consumers already at the present moment feel richer and want to consume more.
On the other hand, an increase in taxes T, in expected future taxes Te or in expected future real interest rates re shifts the IS curve to the left, since in this case consumers limit their current demand.
At this point, just like when looking at the shift in the IS curve without expectations, the combined effect of taxes and government expenditure must be considered. For example, if the government increases taxes T and simultaneously increases government expenditure G, these two effects work together and are added up. So to say, the tax increase is used to finance the increase in government spending. If the two effects are similarly large, the IS curve will approximate the original IS curve.

If, for example, taxes T are increased and government expenditure G is reduced, then both effects taken separately result in the IS curve shifting to the left. If we look at the tax and government expenditure effects together, the IS curve shifts even further to the left by the sum of both effects.

Monetary policy
Now we will take a closer look at monetary policy in the ISLM model with expectations by analyzing the consequences of an expansion of the money supply by the central bank.
First, we assume that an expansive monetary policy does not change expectations about future interest rates or future demand. The LM curve shifts downwards. The equilibrium is now at the point Eq, the intersection of the LM- and the IS curve. Consequently, income increases to Y and the interest rate decreases to r. However, since the IS curve is steep, the expansive monetary policy has only a minor effect on production. As long as changes in the current interest rate do not affect expectations about the future, they have little effect on demand and production.
But is it reasonable to assume that expectations remain unaffected by an expansive monetary policy? It might be much more plausible that if interest rates are cut today, it is assumed they will remain at the lower level in the future. Then the financial markets will expect future demand to be stimulated by low future interest rates. If this is the case, at a given interest rate today, the prospect of low interest rates and high demand in the future will stimulate demand and production already today. Consequently, the IS curve shifts to the right and a new equilibrium is established.
Hence, the impact of monetary policy depends crucially on how it influences expectations. If an expansive monetary policy prompts financial markets, consumers and firms to also consider expectations about future interest rates and production, the effects of an expansive monetary policy can be very large and production and income grow.
If expectations about the future are not affected by the expansive monetary policy, it will have only a minor effect and production and income will increase only slightly. The impact of monetary policy thus depends significantly on its influence on expectations.
If expectations change, the effects of monetary policy are large. If expectations do not change, however, the effects of monetary policy are small.
Expectation formation is not based on arbitrariness, but is done with foresight.
Backloading: reducing the budget deficit with rational expectations
As we have seen above, a restrictive fiscal policy, e.g. saving or tax increases to reduce the government deficit, leads to a decrease of production in the short term. In the medium term, the reduction of the budget deficit has no effect on production, but it does lower the interest rates, thereby induces private investments. In the long term, this higher level of investments increases the capital stock and thus enables a higher level of production.
In the ISLM model with expectations, however, a reduction of the budget deficit can also lead to an increase in private spending and production in the short term if economic actors take the future benefits of deficit reduction already into account today. The effect of an announced deficit reduction includes a decline in current expenditure - the IS curve shifts to the left - and an increase in expected future production when interest rates decrease - the IS curve shifts to the right.
The smaller the cuts in government expenditure today and the larger the cuts later, the stronger the positive demand effect - this concept is called backloading. However, backloading can lead to a credibility problem for the consolidation program, as the biggest cuts are pushed into the future.
Let us summarize: A credible program to reduce the budget deficit can stimulate the economy even in the short term. To do so, the following factors are crucial:

  1. Credibility of the program,
  2. Timeline of the program,
  3. Composition of the program, and
  4. Condition of public finances.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de