Question

Suppose the U.S. government announces that it will bring the federal budget deficit to zero, over the next ten years, with no change in tax rates. Describe the effects of such a policy according to the three business cycle models, assuming that the policy is fully credible

Answer 1

In the traditional Keynesian model, anticipated policy has no effect on expectations, so neither aggregate supply nor aggregate demand is affected. In the new Keynesian model, AS shifts down with the expectation of lower inflation, and AD shifts left with the expectation of lower output (negative demand shock of reduced government purchases). However, the size of both shifts is limited by the size of the expected decrease in the real interest rate and the size of the output response to a lower interest rate. Also, expectations on the real interest rate are affected by expected potential output. If some combination of the content of government purchases, the level of government purchases, and the amount of government borrowing is seen as having an adverse affect on aggregate production, then the anticipated policy creates an expectation of rising productivity. In the extreme, it is possible for the expected decrease in inflation and (thus) in the real interest rate to counteract the decrease in AD. The real business cycle model emphasizes this possibility of a positive productivity shock. If no productivity shock is expected, then the decrease in aggregate demand will lower inflation, while having no effect on output. If a productivity shock is expected, then the decrease in inflation will be smaller, at least until productivity actually rises.