Home > Fiscal Policy, Macro > Short and medium run effects of a fiscal contraction

Short and medium run effects of a fiscal contraction

We can use the ASAD model to look at the short and medium run effects of a fiscal contraction.

You can trace the effects of the fiscal contraction through a few of the short run models:
1. In the Keynesian Cross a decreaase in G shifts the planned expenditure line down, so you get a new equilibrium where planned expenditure (demand) = actual expenditure (output) at a lower level of output.
2. This means that the goods market comes into equilibrium at a lower level of output for all interest rates, so it is reflected in shift inwards of the IS curve.
3. An inward shift of the IS curve means that, keeping the LM curve constant, the goods and money markets come into equilibrium at a lower level of output in the ISLM model.
4. Anything that causes a lower level of equilibrium output in the ISLM model means the goods and money markets are coming into equilibrium at a lower level of output at all price levels, this is reflected in an inward shift (to the left) of the AD curve.

Here we have started from a medium-run equilibrium in the ASAD with output at the natural level (Yn) and price expectations being level with actual prices. The AD curve has shifted in to the left. The effects are that we have got a lower equilibrium level of output, Y2, and that price expectations are now running above actual prices (Pe<P2). This is the short-run effect.

Now we think about what happens to the AS curve. The AS curve will take us back to the medium run, with the adjustment mechanism being price expectations. As price expectations are above actual prices, they will adjust downwards. When expected prices decrease, the AS curve shifts downwards. Remember that in the medium run, output will be back at the natural level, Yn.

Now the AS curve has shifted downwards to take us back to medium run, we are at the natural level of output again and at a point where expected prices equal actual prices. The only difference is the price level is now lower. I have labelled P1 as the original equilibrium price level. We had a short run fall in prices from P1 to P2, before price expectations caught up with them, and then by the time expected prices had caught up with actual prices it was at P3.

What has really gone on here is that the fiscal contraction has reduced output in the short run, which has put downward pressure on prices. When firms have realised that actual prices were below the price expectations they based their last wage claims on, they will adjust their expectations downwards and reflect this in their next round of wage bargaining with workers. The falling prices will be reflected in lower wages which will then decrease firms’ costs, so firms will pass these cost savings onto consumers in the form of lower prices, because they are trying to compete with their rival firms to offer consumers the lowest price. This is why the AS curve is shifting downwards, firms are charging lower prices for the same amount of output, so at all levels of Y, P is lower.

We can also look at the effects on interest rates by tracing out this story in the ISLM model.

The short run effect will be (as described above) that the IS curve shifts in to the left.

Now in the medium run we will go back to the natural level of output, and the ASAD model tells us that it is the price mechanism that will get us there. In the ISLM model, changes in prices are reflected in shifts of the LM curve.

Lower prices will effectively mean an increase of the real money stock, and so this will drive down the interest rate which brings the money market into equilibrium at all levels of output. This is a downwards shift of the LM curve. So the LM curve will shift down to get us back to the medium run where output is at Yn.

So now in the medium run we are back at Yn in terms of output, but have reached a new medium run equilibrium with a lower interest rate. The interest rate has fallen from i1 to i2 in the short run, while output fell from Yn to Y2, but then returned to a medium run level of output, Yn, with a lower equilibrium interest rate, i3.

So the conclusion from this ASAD and ISLM analysis is that a fiscal contraction will cause –
A fall in output, a fall in prices and a fall in interest rates in the short run.
No change in output, but a lower price level and lower level of interest rates, in the medium run.

Categories: Fiscal Policy, Macro
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