21.3.2 Fiscal policy

Fiscal policy measures, i.e. changes in taxes or government spending, can be divided into two categories: restrictive and expansive fiscal policy. Restrictive fiscal policy refers to measures that reduce the government deficit, i.e. a reduction in government expenditure or an increase in taxes. This kind of fiscal policy is called restrictive because it slows down the economy, through fewer impulses given by the state and less disposable income with which citizens can boost the economy. Conversely, expansive fiscal policy measures signify a positive shock to the economy, as lower taxes and higher government spending stimulate the economy directly and indirectly. Using the slider, both expansive and restrictive fiscal policy measures can be shown in the graph.

In the case of restrictive fiscal policy, the signs are reversed in comparison to expansive fiscal policy: appreciation instead of depreciation, recession instead of growth, falling instead of rising interest rates. Therefore, in the following we only describe the interrelationships for expansive fiscal policy measures.

Expansive fiscal policy

If government expenditure is increased from $G_0$ to $G_1$ , slider to the right, the IS curve shifts to the right. The new ISLM equilibrium $G{G}_Z$ with higher interest rates and higher GDP ($y_0$ increases to $y_Z$ and $r_0$ to $r_Z$) is established on the domestic goods market. However, the increased income leads to rising imports and thus to a negative current account balance (fictitious point B in the 3rd quadrant). This shifts the FF-curve upwards, resulting in an imbalance on the foreign exchange market: at the old exchange rate $S_0$ interest rates would have to rise to as high as point A in the 4th quadrant to balance the current account deficit. However, due to the expansive fiscal policy, they actually even rose to $r_Z$ (point C). Although the current and capital account develop in the same direction, there remains an interest rate gap between point A and point C, which represents a positive balance of payments ($K\left(r_Z\right)>-B\left(y_Z,S_0\right)$). This imbalance is also evident from the fact that in this situation the BP($S_0$) line does not pass through the domestic goods market equilibrium.

Primary exchange rate effects

The imbalance on the foreign exchange market is compensated by a market reaction: The exchange rate of the domestic currency appreciates: it falls from $S_0$ to $S_1$. This primary reaction of the exchange rate is purely due to foreign exchange market reactions. Point $G{G}_Z$ in the fourth quadrant lies on the FF-curve to $y_Z$. Due to the imbalance on the foreign exchange market (see explanation for the interest rate gap AC), the exchange rate must appreciate to compensate this imbalance. Although the current account deficit led to an increased supply of domestic currency, the quality of the currency as an investment had increased even more due to higher interest rates.

Secondary exchange rate effects

This appreciation causes domestic exports to fall and imports to rise, and the IS curve shifts back somewhat ($\mathit{IS}\left(G_1,S_1\right)$). As a result, GDP falls back slightly to $y_1$ and interest rates moderately to $r_1$. However, this secondary impulse is much weaker than the primary shock. As the exchange rate falls, the BP-curve shifts slightly to the left due to the negative current account effect and now passes through the new final equilibrium $G{G}_1$. In addition, the decline in GDP leads to a moderate shift of the FF curve downwards, so that an equilibrium $G{G}_1$ at $r_1$ and $S_1$ is also established on the foreign exchange market. The current account balance is clearly negative, since, overall, both the increase in GDP and the appreciation have a negative impact on the current account.

Conclusion:

The expansive fiscal policy causes an appreciation of the currency, which, by increasing imports, dampens the growth impulse and lessens the interest rate impulse. A part of government demand is thus satisfied by foreign countries and cannot have a growth-promoting effect.