Reinventing fiscal policy

Abstract

Recent developments in macroeconomic policy, both in terms of theory and practice, have elevated monetary policy while fiscal policy has been downgraded. Monetary policy has focused on the setting of interest rates as the key policy instrument, along with the adoption of inflation targets and the use of monetary policy to target inflation. Elsewhere we have critically examined the significance of this shift, which led us to question the effectiveness of monetary policy. We have also explored the role of fiscal policy and have argued that fiscal policy should be reinstated. This contribution aims to consider further that particular conclusion. We consider at length fiscal policy within the current "new consensus" theoretical framework. We find the proposition of this thinking, that fiscal policy provides at best a limited role, unconvincing. We examine the possibility of crowding out and the Ricardian Equivalence Theorem (RET). A short review of quantitative estimates of fiscal policy multipliers gives credence to our theoretical conclusions. Our overall conclusion is that, under specified conditions, fiscal policy is a powerful tool for macroeconomic policy.

Keywords:

• crowding out
• fiscal policy
• Ricardian Equivalence Theorem