The Effect of Fiscal Policy

Three Cases of Fiscal Expansion

Government spending may include current spending and/or future spending. The same is true for taxes. The size of the multiplier depends upon how government spending and taxes change over time. In the neoclassical model, households behave rationally in the sense that they optimize consumption and saving plans in consideration of future fiscal changes and current fiscal policy. In this regard, it is useful to investigate the effect of fiscal policy in the following three cases.

  • (i) Temporary expansion: Current government spending increases but permanent government spending does not (AG > 0, AGp = 0).
  • (ii) Permanent expansion A: Current government spending does not increase but permanent spending increases (AG = 0, AGp > 0).
  • (iii) Permanent expansion B: Both current and permanent government spending increase(AG = AGp > 0).

In case (i), future spending declines in order to offset current expansion; thus, permanent government spending remains fixed. In case (ii), future government spending is committed to increase; thus, permanent spending increases although current spending remains fixed. Case (iii) is regarded as the sum of case (i) and case

(ii).

 
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