Question #2120

A program of fiscal austerity, defined as the government running a fiscal surplus, does not necessarily undermine economic growth.

Answer #10664

Answer: True

Explanation

The answer is True.

To understand why you have to appreciate that generally a fiscal surplus, which drains net spending from the economy will undermine growth, on the principle that spending equals income equals output.

But, that conclusion is only true if we assume no change in the spending positions of other sectors.

In other words, the spending drain from the fiscal drag can be offset (unlikely) by an increase in spending of one or more of the non-government sector.

We define total spending and income as:

GDP = C + I + G + (X - M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X - M).

Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.

We consider the 'injections' to spending (from 'outside') the circular spending-income flow to be I and G and X.

We consider C and M to be determined by GDP so there is circularity in the national income statement above.

In that context, we also define 'leakages' from the spending-income flow.

These are:

1. Saving (S) which is the difference between disposable income and consumption spending. Disposable income is total GDP minus Taxes (T).

So when households earn income they do not recycle all of it back into spending each period because they save some of it.

2. Taxes (T) go to government and are lost from the spending cycle.

3. Imports (M) are driven by GDP but the income is lost to the rest of the world.

So we have some injecctions into spending from 'outside' the cycle, and some leakages from the cycle.

We know that for GDP (national output) to remain constant, the injections into the expenditure stream have to equal the leakages.

Thus:

S + T + M = I + G + X

This is called an equilibrium or steady state condition in macroeconomics.

It doesn't imply full employment or a 'good' outcome. It means that once this condition is satisfied, there are no forces present to change GDP.

For GDP to change, there has be a change in one of the terms, which then create income shifts that bring the leakages and injections back into equality.

If, for example, G increases as part of an expansionary policy then GDP increases and this leads to increased S, T and M.

Ultimately, once the spending multiplier is exhausted, the left-hand side (S + T + M) rises to equal the rise in the right-hand side (I + G + X) that was stimulated by the increase in G, and GDP comes to rest again at a higher level.

Please read my blog post - Spending multipliers (December 28, 2009) - for more discussion on this point.

So we can now appreciate that if the government imposes fiscal austerity by, for example, cutting government spending (G), if nothing else changes, GDP will fall and the new steady state will be reached when the initial change in G is matched by the decline in S, T and M, all of which are sensitive to changes in GDP.

But, that is not an inevitable outcome.

If the government, for example, is anticipating a major export boom, then it could start cutting G as exports (X) rise which would offset the initial austerity.

The following blog posts may be of further interest to you: