Expansionary Fiscal Contraction Hypothesis

Expansionary fiscal contraction can occur under certain assumptions whereby a major reduction in G changes future expectations about taxes and G which leads to an increase in C causing higher GDP if the rise in consumption exceeds the fall in G. This can only happen if government expenditure as a percentage of GDP is reduced significantly to lessen crowding out and allow the private sector to expand. We need to assume that the economy is at full employment for fiscal contraction to be expansionary.

There are three mechanisms for why this may occur: the belief of Ricardian Equivalence, crowding out theory or market sentiments.

Fiscal contraction may lead consumers to believe that a permanent tax reduction in the future will take place, resulting in a positive wealth effect causing an increase in consumption. It follows on from the theory of Ricardian Equivalence. If the positive ΔC is greater than the negative ΔG then the fiscal contraction has been expansionary.

Others propose that fiscal contraction can be expansionary because government crowds out private investment. A fall in government borrowing should lower interest rates which would make private investment and consumption of expensive goods cheaper, and may therefore boost these two components of aggregate demand, offsetting government spending. However, this channel assumes that lower interest rates are passed on to businesses; in periods of low confidence and banking crises this may not be guaranteed.
It may be the case that the government’s fiscal stance affects market sentiment, and that fiscal retrenchment would increase market confidence – perhaps because there is a reduced fear of government default (despite the ability to print money). We can use the following investment function – I = a + b(T-G) – where b is the sensitivity to confidence channels linking fiscal solvency of the government to investor confidence. If T-G falls (fiscal contraction) then this investment function will show that I will rise. If b is greater than 1 then fiscal contraction will have a positive multiplier effect. However this model doesn’t take into account the fact that government spending heavily effects the demand for private sector goods and services, so a reduction in government spending is likely to lead to a fall in demand which will reduce profits which may be linked (in reality) to investor confidence and the willingness to finance investment. a in this investment function is autonomous investment which would occur regardless of other factors, it may be due to the level of investment necessary for firms to replace depreciated capital. More importantly, fiscal contraction would only be expansionary if ΔI > ΔG, where our investment function means that ΔI should be positive and ΔG should be negative.

Islam and Choudhury find that the probability of fiscal contraction being expansionary is between 19% and 25% but are ultimately against such an idea which has gained favour in recent times due to government actions and a need for economic doctrine to support this.

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