Fiscal Policy in Classical and Keynesian Open Economies

One of the important components of the programme of presidential candidates are economic measures which would be undertaken and the effect of these economic measures. In particular, an important component of economic and political program is fiscal policy – the use of taxation and government spending in order to balance the economy. There are three possible approaches to fiscal policy – expansionary, balanced and restrictive fiscal policy, and two views on the effect of the fiscal policy on the economy – classical and Keynesian (Gwartney et al, 2008). The purpose of this paper is to analyze the outline of Romney’s fiscal policy from these two perspectives, identify which perspective better matches current economic situation, generate fiscal policy recommendations and update them with regard to the recent findings on the relationship between government debt and GDP growth.

1. Romney’s fiscal statements and suggestions

In order to analyze Romney’s fiscal policy, it is first of all necessary to identify its main elements. In the excerpt of political debate, Romney mentioned the following statements related to fiscal policy: keeping a balanced budget (which means reduction of budget deficit), not reducing taxes for high-income families and not increasing taxes for middle-income families (taxes for these groups therefore supposed to be the same), reduction of taxes for the lower-income group, decrease of government spending (he mentioned lowering spending in order to encourage economic growth). Romney also expressed confidence in the increase of employment as a result of tax reduction for small business (i.e. people engaged in small business will start hiring more workers once their taxes are reduced). Current economic situation is characterized by high unemployment and high government debt; overall, the economy is in the recession period, so the analysis will be held with regard to the recession situation for both classical and Keynesian economical views.

3. Classical view on fiscal policy

According to classical theory, the economy is guided by the invisible hand of the market, and therefore, the most reasonable approach to fiscal policy is laissez-faire. The main assumptions of classical theory are the following: market is fully competitive, prices and wages are flexibly adjusted, people are not vulnerable to “money illusion” and act as reasonable and informed participants of the economic system (Shmidt-Hebbel and Serven, 1994). Classical theory supports Say’s law: supply creates own demand (Shmidt-Hebbel and Serven, 1994), i.e. there cannot be oversupply in the economy, because people spend in accordance with their desires, and actual expenditures are the same as desired expenditures. In this model, the effect of the fiscal policy is minimal, and, therefore, the government should keep the budget close to the balance and avoid financial interventions in the economy.

Romney’s tax cuts, according to the classical model, will lead to the increase in consumption and to the decrease of investments due to the crowding-out effect. On the other hand, decrease in government spending might balance this effect (due to the balance S+T=I+G) (Gwartney et al, 2008). If government spending will decrease by the same value as taxes, then the effect on investment might be minimal. Therefore, total spending, output, investment and interest rates are expected to remain unchanged in the long run, according to classical theory.

2. Keynesian view on fiscal policy

In Keynesian model, the assumptions are the following: prices and wages are not flexible, and changes of aggregate demand do not affect price level (Shmidt-Hebbel and Serven, 1994). It should be noted that neo-Keynesian theory does recognize the effect of demand change on prices, but stresses out the slowness of this change. In this model, GDP is demand-driven, and government should actively pursue fiscal policy in order to stimulate economic growth. In recession times, the government should adhere to expansionary policy, i.e. increase government spending and reduce taxes (Shmidt-Hebbel and Serven, 1994). From this perspective, tax reduction will stimulate consumption and investments, and decrease of government spending will have an adverse effect – reduce investments and demand for credit. In this case, the effect of the policy will depend on the difference between the change in government spending and the change in taxes. Taking into account the “balanced budget” statement of Romney, it is likely that decrease of government spending will be greater than tax reduction. In this case, interest rates will reduce, investment will increase, and the output will increase as well.

4. Consideration of current economical situation

The approach in Romney’s plan combines elements of classical approach (balanced budget) and Keynesian approach (tax reduction). With regard to the current situation, it is reasonable to adopt neo-Keynesian assumptions rather than classical assumptions. Indeed, prices and wages do not change flexibly – there are contracts and long-term agreements which generally prevent this (Gwartney et al, 2008). At the same time, prices are not totally inflexible, and change over time to match the demand – but in the short run, prices and wages can be viewed as constant. Therefore, neo-Keynesian view on the perspective seems to be more appropriate.

5. The impact of federal debt on the U.S. economy

The findings of Reinhart and Rogoff (2010) show that there is no significant relationship between GDP growth and the value of government debt if the debt/GDP ratio is below 90%; for debt/GDP ratios of 90% and higher, growth rates fall. The findings also indicate that there is no relationship between the debt/GDP ratio and inflation, and for the USA, for example, higher inflation was witnessed when debt/GDP ratios were high (Reinhart and Rogoff, 2010). The findings of Reinhart and Rogoff indicate that Keynesian assumption about the stimulation of the economy with increased government spending (expansionary fiscal policy) might not be true. In the light of this research, it is more reasonable to support classical and neo-classical views.

Conclusion

The analysis of Romney’s suggestions on fiscal policy from classical and Keynesian perspectives showed that from classical perspective, this policy would not have significant effect on key macroeconomic variables, and from Keynesian perspective, this policy would stimulate investment and economic growth. Although the major assumptions of neo-Keynesian theory seem to be more appropriate for the current economic situation, in-depth research of Reinhart and Rogoff  (2010) shows that the assumptions of classical and neo-classical theories might rather be true. In the light of these findings, it can be recommended to adhere to the laissez-faire policy and focus on the balanced budget without changing taxes or government spending.