Curiosity 7.1: What Is the Balanced-Budget Multiplier?
The multiplier assumes that the increase in government spending is financed by selling bonds to the public. When the increase in government spending is financed by raising taxes, this multiplier is called the balanced-budget multiplier. This name reflects the fact that in this case the fiscal action has no impact on the size of the government's budget deficit or surplus.
An increase in government spending of one dollar increases aggregate demand by one dollar, but an increase of taxes by one dollar decreases aggregate demand by less than one dollar, because the extra dollar for taxes comes partly from reducing saving. Consequently, a net positive impact on aggregate demand results from a balanced-budget change in government spending. We can conclude that the Keynesian multiplier process does not necessarily require creation of a budget deficit.
The balanced-budget multiplier is quite small, however, rendering unconvincing the Keynesian plea for fiscal policy in this context. In very simple models of the economy it is easy to show that the balanced-budget multiplier is 1.0. More realistic models of the economy that incorporate automatic stabilizers, however, push this number well below 1.0.
2. Smoothing consumption. When the bonds mature, interest and principal must be paid to the bondholders. People may believe that future taxes will be higher as a result and react by increasing saving (decreasing current consumption demand) to build up a reserve so that those anticipated higher taxes can be paid without disrupting future consumption levels.
Printing Money
Financing increases in government spending by raising taxes or by selling bonds to the public leaves the supply of money in the economy unchanged, resulting in what is called a pure fiscal policy. In contrast, financing by selling bonds to the central bank increases the money supply. When buying a government bond (or any bond, for that matter), the central bank writes a check against itself and thereby creates money out of thin air. This fact explains why this means of financing is referred to as printing money. The U.S. central bank is often referred to as ''the Fed," short for the Federal Reserve System. (Chapter 8 explains the money creation process in more detail.)
Although printing money seems like an attractive way for a government to finance its spending, readers should be warned that printing too much money creates inflation. In the absence of an independent central bank, politicians tend to print too much money, explaining why many countries experience high inflation rates. Chapter 9 explains the link between inflation and money creation.
Financing by printing money mixes a fiscal policy of increased government spending with a monetary policy of increasing the money supply. In this case, there are no crowding-out effects due to the financing means. The operation of the multiplier is in fact strengthened by
