Question of the Week

Which of the following statements most accurately describes the impact of an expansionary fiscal policy under the New Classical Model?

A) Increased government spending today will boost current aggregate demand, however, this will come at the cost of a reduction in aggregate demand in the future, as the government begins to repay its debt.
B) The resulting budget deficit will be lead to increased levels of private savings, thus leaving the level of real interest rates unchanged.
C) As the government increases its expenditures through borrowing, the multiplier effect will ensure that aggregate demand will still increase significantly despite any slowdowns that may result from the crowding out effect.
D) The resulting budget deficit will lead to excess government borrowings, which will in turn lead to much higher level of real interest rates, holding the flow of foreign capital constant.


The correct answer is: b)

The foundation of this model is the "Ricardian equivalence", which states that an expansionary fiscal policy is either possible by increasing taxes or by increasing the amount of borrowing. If this is so, then government borrowing is equivalent to increasing taxes. An illustration will help. If the government were to finance a spending increase by increasing taxes by an equivalent amount, there would be no impact on the economy. On the other hand, if this increase in spending were financed via debt today, then the government would have to find a way to pay this debt back in the future. This would most likely be achieved by increasing future taxes. Consequently, borrowing today will lead to higher taxes in the future. In response, individuals and businesses will begin saving more today so that they will have enough to pay higher taxes in the future. However, this increased private saving today will mute the effect of any spending that the government may embark upon. The result is that fiscal policy becomes ineffective in influencing the economy; although the government will now command a greater proportion of economic activity. Note that the simultaneous events of increased private savings and increased government borrowings will offset each other so that real interest rates remain unchanged. In summary then, the New Classical Model stipulates that fiscal policies will have no impact either on aggregate demand nor the real level of interest rates, certainly a statement that runs counter to Keynesian models.

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