18.2 Fiscal Policy and the Trade Balance

Fiscal policy and budget deficits are crucial elements of macroeconomic management. They involve government spending, taxation, and borrowing decisions that impact economic growth, stability, and international trade. Understanding these concepts is essential for grasping how governments influence economic outcomes.

The twin deficits phenomenon highlights the connection between budget deficits and trade imbalances. Government borrowing can affect exchange rates, influencing exports and imports. During recessions, expansionary fiscal policy can stimulate the economy, but it also poses challenges like inflation and long-term debt sustainability.

Fiscal Policy and Budget Deficits

Concept of twin deficits

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• Twin deficits occur when a government runs a budget deficit alongside a current account deficit in the balance of payments
  • Budget deficit happens when government expenditure surpasses tax revenue collected (U.S. federal budget deficit reached $3.1 trillion in 2020)
  • Current account deficit arises when a country's imports exceed its exports, indicating a trade imbalance (U.S. current account deficit was $616 billion in 2020)
• Budget deficits can lead to trade imbalances through various mechanisms
  • Government borrowing to finance deficits raises interest rates, attracting foreign capital inflows (U.S. Treasury bonds)
  • Capital inflows appreciate the domestic currency, making exports costlier and imports cheaper (U.S. dollar appreciation)
  • Reduced net exports (exports minus imports) contribute to a larger trade deficit (U.S. trade deficit with China)
• Twin deficits have significant implications for an economy
  • Greater dependence on foreign borrowing to fund government spending
  • Heightened economic instability and exposure to external shocks (global financial crisis)
  • Impact on national savings, as government borrowing reduces overall savings in the economy

Government borrowing and exchange rates

• Exchange rates are influenced by government borrowing through the interest rate channel
  • Increased government borrowing raises demand for loanable funds, driving up interest rates (U.S. Federal Reserve raising interest rates)
  • Higher interest rates attract foreign capital, leading to an appreciation of the domestic currency (U.S. dollar strengthens against the euro)
• Currency appreciation affects international trade dynamics
  • Exports become more expensive for foreign buyers, reducing export demand (U.S. exports to Europe become costlier)
  • Imports become relatively cheaper for domestic consumers, increasing import demand (U.S. consumers buying more European goods)
  • The overall effect is a worsening of the trade balance as net exports decline (U.S. trade deficit widens)
• Persistent trade imbalances have long-term consequences
  • Accumulation of foreign debt over time (U.S. foreign debt held by China and Japan)
  • Erosion of international competitiveness (U.S. manufacturing sector)
  • Increased economic vulnerability and reliance on foreign financing (U.S. dependence on foreign creditors)

Fiscal Policy and Economic Stability

Budget deficits and economic stability

• Budget deficits can fuel inflationary pressures in the economy
  • Deficit spending boosts aggregate demand, potentially exceeding the economy's productive capacity (U.S. stimulus packages during the COVID-19 pandemic)
  • Excess demand puts upward pressure on prices, leading to inflation (U.S. inflation rate surging to 5% in 2021)
• Financing budget deficits by monetizing the debt can exacerbate inflation
  • Central banks purchasing government bonds increases the money supply (U.S. Federal Reserve's quantitative easing)
  • Rapid money supply growth can drive up inflation rates (hyperinflation in Venezuela)
• Budget deficits can undermine economic stability in various ways
  • Crowding out of private investment as higher interest rates discourage borrowing (U.S. businesses delaying expansion plans)
  • Reduced private sector confidence and investment due to concerns over long-term fiscal sustainability (U.S. national debt exceeding $28 trillion)
  • Heightened vulnerability to external shocks and financial crises (European debt crisis)

Fiscal policy in recessions

• Expansionary fiscal policy can help alleviate economic recessions
  1. Government increases spending on goods, services, and infrastructure projects to stimulate aggregate demand (U.S. government funding highway construction)
  2. Tax cuts or transfers to households boost disposable income, encouraging consumption (U.S. stimulus checks to citizens)
  3. The multiplier effect magnifies the initial spending increase, leading to a larger impact on output and employment (U.S. unemployment rate falling after stimulus measures)
• Expansionary fiscal policy faces challenges and limitations
  • Time lags in implementation and impact of fiscal measures (U.S. Congress debates on stimulus bills)
  • Potential inflationary pressures if the economy is already operating near full capacity (U.S. economy overheating concerns)
  • Long-term fiscal sustainability concerns, especially if deficits persist beyond the recession (U.S. national debt-to-GDP ratio rising)
• Contractionary fiscal policy can help curb overheating and inflationary pressures during economic expansions
  • Government reduces spending or raises taxes to cool down aggregate demand (U.S. government spending cuts in the 1990s)
  • Helps maintain price stability and prevents asset bubbles (U.S. Federal Reserve raising interest rates to control inflation)
  • May be necessary to restore fiscal balance and reduce government debt levels over the long term (U.S. budget surpluses in the late 1990s)

Keynesian Economics and Fiscal Policy

• John Maynard Keynes advocated for active government intervention in the economy
• Keynes emphasized the role of aggregate demand in determining economic output
• Fiscal policy can be used to manage aggregate demand and stabilize the economy
  • Discretionary fiscal policy involves deliberate changes in government spending or taxation
  • Automatic stabilizers, such as unemployment benefits, help smooth economic fluctuations
• The fiscal multiplier concept suggests that government spending can have a magnified effect on the economy
• Open economy macroeconomics considers how fiscal policy impacts international trade and capital flows