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The unintended consequences of the debt: Will increased government expenditure hurt the economy?

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  • Werner, Richard A.

Abstract

In 2008, governments in many countries embarked on large fiscal expenditure programmes, with the intention to support the economy and prevent a more serious recession. In this study, the overall impact of a substantial increase in fiscal expenditure is considered by providing a novel analysis of the most relevant recent experience in similar circumstances, namely that of Japan in the 1990s. Then a weak economy with risk-averse banks seemed to require some of the largest peacetime fiscal stimulation programmes on record, albeit with disappointing results. The explanations provided by the literature and their unsatisfactory empirical record are reviewed. An alternative explanation, derived from early Keynesian models on the ineffectiveness of fiscal policy is presented in the form of a modified Fisher-equation, which incorporates the recent findings in the credit view literature. The model postulates complete quantity crowding out. It is subjected to empirical tests, which were supportive. Thus evidence is found that fiscal policy, if not supported by suitable monetary policy, is likely to crowd out private sector demand, even in an environment of falling or near-zero interest rates. As a policy conclusion it is pointed out that by changing the funding strategy, complete crowding out can be avoided and a positive net effect produced. The proposed framework creates common ground between proponents of Keynesian views (as held, among others, by Blinder and Solow), monetarist views (as held in particular by Milton Friedman) and those of leading contemporary macroeconomists (such as Mankiw).

Suggested Citation

  • Werner, Richard A., 2011. "The unintended consequences of the debt: Will increased government expenditure hurt the economy?," CFS Working Paper Series 2011/26, Center for Financial Studies (CFS).
  • Handle: RePEc:zbw:cfswop:201126
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    References listed on IDEAS

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    1. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
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    4. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1, June.
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    6. Asako, Kazumi & Ito, Takatoshi & Sakamoto, Kazunori, 1991. "The rise and fall of deficit in Japan, 1965-1990," Journal of the Japanese and International Economies, Elsevier, vol. 5(4), pages 451-472, December.
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    More about this item

    Keywords

    Credit; Crowding Out; Equation of Exchange; Fiscal Policy; Japan; Monetarism; Monetary Policy; Quantity Equation;

    JEL classification:

    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
    • H60 - Public Economics - - National Budget, Deficit, and Debt - - - General
    • O42 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Monetary Growth Models

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