There is no such thing as fiscal policy

It can be rather traumatic for children to see their parents fight. I feel a bit like that when I see two of my heroes Scott Sumner and David Glasner discuss fiscal policy. The whole thing started with Scott picking a fight with a couple of Keynesians. To be frank that discussion really didn’t turn me on and even though I read most of what Scott writes this was not a discussion that I was particularly interested in. And it is certainly not my plan to address what the discussion really is about – let me just say I think Scott makes it unusually complicated – even though I think he is right (I guess…). Instead I will try to explain my view of fiscal policy or rather to explain why I think there really is no such thing as fiscal policy – at least not in the sense that Keynesians talk about it.

In an earlier post – “How I would like to teach Econ 101” – I have explained that there seems to be a disconnect between how economists think about microeconomics and macroeconomics. I think this disconnect basically also creates the misunderstanding among Keynesians about what fiscal policy is and what it can do.

The way we normally think of microeconomics is an Arrow-Debreu world with no money. Hence, we have a barter economy. As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand. Furthermore, it is not possible, as public expenditures in barter economy basically have to be funded by “forced labour”. “Taxes” will be goods that somebody is asked to “pay” to government and government “spend” these “revenues” by giving away these goods to other people. Hence, in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”.

Therefore for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.

Lets start out with the standard Keynesian stuff:

(1) Y=C+I+G+X-M

Where Y is GDP (nominal GDP!), C is private consumption, I is investment, G is government expenditure, X is imports and M is imports. There is nothing wrong with this equation. It is an identity so that is no up for discussion.

Lets make it a little simpler. We assume that we have a closed economy so X=M=0. Furthermore lets assume that we define “private demand” as D=C+I and lets write nominal GDP as P*Y (Keynesians assume the P=1). Then we get the following equation:

(1)’ P*Y=D+G

In the barter economy P*Y is basically fixed hence it must follow that an increase in G must lead to a similar decrease in D. There is full crowding out.

So lets introduce money with another identity – the equation of exchange:

(2) M*V=P*Y

Combining (1)’ and (2) with the following:

(3) M*V=D+G

This basically explains why Scott keeps on talking about monetary policy rules when he discusses fiscal policy. (By the way this is a very simple IS-LM model).

Hence, the impact of fiscal policy on nominal GDP/aggregate demand crucially dependents on what happens to M and V when we increase G.

Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.

However, lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.

There, however, is one more possibility and it is that a change in G in someway impacts money-velocity (V). This is what happens in the traditional IS-LM model. Here an increase in G increases “the” interest rate. As the interest rate increases the demand for “bonds” increases and the demand for money drops. This is the same as an increase in V. This model in my view is rather ridicules for a whole lot of reason and I really should not waste people’s time on it, but lets just say that the whole argument breaks down if we introduce more than the two assets – money and “bonds” (Google Brunner and Meltzer…). Furthermore, lets say that we are in a small open economy where the interest rate is given from abroad then changes in G will not influence the interest rate (as least not directly) and hence fail to impact V. If the interest rate is determined by inflation expectations (or NGDP expectations) then the model also breaks down.

But anyway lets assume that this is how the world works. But lets also assume that the central bank has a NGDP level target. Then the increase in G will lead to a drop in money demand via a higher interest rate and thereby to an increase in V. However, as the central bank targets a fixed level for NGDP (M*V) an increase in V will have to be counteracted by an “automatic” drop in M. So again the monetary policy reaction function is crucial. In that sense it is also rather tragic that we had a long debate during the 1970s between old style Monetarists and Keynesians about the size of the interest rate elasticity of investments and money demand with out having any discussion about how this was influenced by the monetary policy rules. (This is not entire true, but bare with me).

One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.

That said, fiscal policy of course can have an impact of the supply side of the economy and that is ultimately much more important – especially as the ill (lack of aggregate demand) the Keynesians would like to cure cease to exist if the central bank targets the NGDP level.


PS don’t expect me to write a lot more about fiscal policy. The idea that fiscal policy can be used to “stimulate” aggregate demand is just too 1970s for me. Even New Keynesians had given up on that idea during the “Great Moderation”, but some of them now seem to think it is a great idea. It is not. And no this is not some “Calvinist” idea I have – I just don’t think it will work.

UPDATE: Scott continues the fiscal debate (lets stop it Scott, we won long ago…)

UPDATE 2: Sorry for the typos…trying to write fast – sitting in Warsaw airport waiting to board on my flight back home to Copenhagen.

UPDATE 3: Back home with my fantastic family in Denmark – while my family is now asleep I see that Scott has yet another fiscal policy comment.

UPDATE 4: Nick Rowe sketch a very similar model to mine. Apparently Danish and Canadian monetarists think alike.

Leave a comment


  1. cthorm

     /  January 18, 2012

    Do Widzenia Lars. Well said about effective “fiscal policy” really just being monetary policy. I can’t wait for this pissing match to end.

  2. Dzięki cthorm…Scott just need to let out some steam. Soon we will be back to monetary policy again…

  3. Integral

     /  January 19, 2012

    Well, he is getting a record number of comments out of it, so he’s either doing something very right or making everyone very confused. On the other hand, I’ve lost track of who’s claiming what anymore.

    It’s gotten to the point that I have stopped commenting; there’s no incentive when it’ll just get lost in the flood.

  4. Excuse my ignorance, but why would an increase in government spending cause an increase in the interest rate?

  5. The reason I ask is that I can imagine one scenario where fiscal stimulus would fail to increase aggregate demand even when accommodated by monetary policy.

    Suppose that, due to spiraling deficits and unfunded liabilities, government bonds are significantly downgraded. Even 3-month T-bills become high risk assets. It seems highly unlikely that the Federal Government would try a fiscal stimulus under these circumstances, but this is a thought-experiment, so roll with it. Assume the government attempts to stimulate aggregate demand by selling bonds to finance additional spending.

    It seems to me that such a fiscal stimulus would be wholly ineffective even when not sabotaged by monetary policy, because the effect on velocity would be negligible. (If anything, concerns of government default would probably spur money demand and suppress nominal GDP even further, but hold it constant for the sake of argument.) The problem is that government bonds are no longer a close substitute for holding money: increasing their supply doesn’t induce people to hold smaller money balances.

    Would interest rates rise? Probably. Would velocity increase? Probably not. Am I just getting this horribly wrong?

    • cthorm

       /  January 19, 2012

      >Suppose that, due to spiraling deficits and unfunded liabilities, government bonds are significantly downgraded.

      As the August 2011 US downgrade showed, downgrades don’t matter. It’s all relative. See Bill Gross’ “cleanest dirty shirt” narrative.

      >If anything, concerns of government default would probably spur money demand and suppress nominal GDP even further, but hold it constant for the sake of argument.

      Actually, under the scenario you outlined I think it’s FAR more likely that demand for money would collapse, greatly increasing velocity. This is a classic Weimar Republic scenario. If the government controls the currency, and the government is approaching near-term default, you are likely to get hyper inflation. What commerce remains will probably be done in alternative currencies (see the prevalence of USD in Zimbabwe). Interest rates would rise because inflation expectations would be truly unhinged.

    • Nick, old monetarist habits ever dies;-) But yeah our models are basically the same. Why did Scott not just write down our model?;-)

  6. cthorm,

    I was thinking about a much bigger downgrade. However, you’re right, I implicitly assumed that government bonds became more risky relative to holding money, but a reasonable word count demands that some things get omitted. My intent was merely to sketch a scenario where government bonds became a less close substitute for money balances, and then explain why this would reduce the efficacy of fiscal stimulus irrespective of what happens to interest rates. Perhaps the scenario I imagined was badly chosen or described; I invite you or anyone else to come up with something better.

    As for your other point, I think the Federal Government is far more likely to default than inflict severe inflation on its citizens, especially when so much U.S. debt is held by foreigners. I’d expect rising money demand merely because people hoard money when they’re scared, and I imagine there would be a lot of upheaval and uncertainty following a federal default.

    • cthorm

       /  January 19, 2012

      Lee Kelly,

      I think my response applies if short-term bonds increase in risk relative to holding money as well. The scenario applies to a situation like Greece, but the effect could be seen even for countries with sovereign currencies when they issue bonds in another currency (Yankee/Euro bonds). I’m not sure why this would decrease the efficacy of fiscal stimulus, but that seems like a strange thing to be worried about in such a situation. I take the view of RP Feynman on this: you shouldn’t try to predecide what you’re looking for, let nature (the effects) show itself as it is.

      As to how the US Gov’t will handle it’s debt load, I think history has shown how it will be handled. Not through “severe inflation” but through persistent modest inflation, of say 2-4% over thirty years. It was much the same for US debt from 1940-1980. In the event of eminent default/hyper inflation I don’t think you see people hoarding paper money, they hoard alternative assets like gold.

      • My point is that the substitutability of money balances and government bonds should not be assumed to be constant. I was trying to describe a situation in which they became distant substitutes for illustration. To the degree that government bonds are just another asset, and not a close substitute for money balances, fiscal stimulus would be less effective regardless of changes in interest rates.

  7. Lee & cthrom, I can actually imagine a situation where an “unsustainably” loose monetary policy increase the expectation that the public debt will be monetized sooner or later. That will lead to a drop in money demand AND increase interest rates. The drop in money demand will be that same as monetary easing if the money supply is kept constant. I am not sure how relevant this is empirically, but theoretically it makes perfect sense. I have written a bit about this before:…/

  8. Benjamin Cole

     /  January 20, 2012

    “One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.”–Lars

    Exactly–and why I say there are only two kinds of economists, Market Monetarists and Theo-Monetarists. Keynesians are Market Monetarists in drag.

    Theo-Monetarists believe that controlling inflation is sacred, and somehow doing such leads to growth. They have faith, they mumble, thy dither, they like to have secret FOMC meetings, they love gold and the stagnant value of paper money.

    Market Monetarists insist on taking responsible and sensible monetary actions to help the economy grow, in clear, transparent and manifest policy actions.

  9. Michael Carroll

     /  January 20, 2012

    Quick question.

    If Y=nominal GDP
    and you write:
    PY = nominal GDP

    did you mean to write

    PY’ = nominal GDP = Y

    where Y’ = real GDP?

    • Mchael, in the Keynesian formulation P is assummed to be 1 so P*Y=1*Y=Y. So real GDP is equal to nominal GDP – this is the standard keynesian set-up.

      • Michael Carroll

         /  January 20, 2012

        Yeah, I saw that. And sorry to belabor this, but if I was translating from the Keynsian set-up by changing P then Y’ is real GDP right?

        (I am looking at Nick Rowe’s comment on Wren-Lewis’s Jan 19th post where he discusses inflation from period 1 to period 2.

        if I wrote:

        P(1)Y/M(1)V = P(2)Y/M(2)V

        Y is real GDP in both cases right?


  10. Michael, I am not sure about your equation. But yes, in the standard equation of exchange MV=PY Y is real GDP. I can’t however find your two period equation in Nick’s post

    • Michael Carroll

       /  January 21, 2012


      On the one hand that equation was just my way of forcing you to answer my freshman econ question.

      BUT… on the other hand when Nick says: “Period one really needs to be short. Because if Y increases in period one, inflation will rise too.” I am trying to reconcile this with the idea that real GDP is not going to change so holding real GDP and V constant, a change in P could imply an inverse change in M. So then I get it that in this “Moneterist Parody” (to borrow from NR) ,model nominal GDP can change while real GDP doesn’t (and my head stops exploding).

  11. Michael, I am not entire sure still about how to answer the question. Basically I am not sure how Nick’s two-period model is formulated compared to my one period “model”. That said, I am pretty sure that Nick and I have the same model in our heads.

    • Michael Carroll

       /  January 22, 2012

      You DID answer my question! I just wanted to be sure I was keeping track of nominal vs. real GDP properly. Again sorry for the confusion.

      Anyway, thanks.

  12. Michael, you are very welcome. I hope you will keep following my blog.

  13. felipe

     /  August 7, 2012

    HI Lars,

    Sorry for the late comment, but I just came upon this post via a series of link clicks.

    I think you may be overreacting when you say “there is no such thing as fiscal policy”. While I fully agree that fiscal policy can only happen when the central bank plays along, there is an argument to be made that monetary policy can be more effective when fiscal policy plays along, if we take distributional effects into account.

    Suppose that the CB is willing to play along to fiscal policy, by not shrinking M if growth starts to pick up, then the government can very much increase V by taking some money and giving it to people with no capacity to save. Since these people have no capacity to save, there is no money hoarding going on, so V increases. Why is it important the low capacity to save? Because increasing private savings need not magically turn itself into more private investment. For once, economies aren’t really closed anymore, so excess savings can go somewhere else and finance investment in some other country. Second, excess savings need not be taken by/offered to the private sector, but the government.

    I keep thinking that today’s fed is doing the job wrongly because, even though M has greatly increased, it keeps sitting in the fed accounts, thereby making V smaller by the same (or similar) amount. If the fed were instead to give that extra M to the goverment to *actually go out on helicopters and drop money into the streets*, the US would be in a much better place now.

    It seems to me that you have arguments to suggest I’m wrong, otherwise you wouln’t say that fiscal policy doesn’t exist. Maybe I’m just saying that monetary policy can work best when it is done as fiscal policy.

  14. “there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment….”

    So floods and droughts never make it impossible for people to produce, and there is no such thing as famine due to crop failure.


  15. Jan

     /  August 28, 2013


    There´s no crowding out during a recession. I private spending falls, and the private sector pays back more loans than it takes out, the money supply will contract if the government stays ´neutral´. The government will borrow and spend the reserves that the private sector does not want to borrow and spend, this sustains aggregate demand. If increases in Mb do not translate into increases in M with neutral fiscal policy, expansionary fiscal policy is required.
    This is theory, you will claim that monetary policy can always increase private demand, but that is not the issue here, but your claim about ´crowding out´.

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