becomes ambiguous. In the medium run, deficit reduction leads to a fall in the real interest rate and to an
increase in investment. A permanent increase in investment leads to an increase in capital accumulation.
Therefore, in the long run, deficit reduction leads to an increase in output. In terms of equation (16.2),
Y’eincreases andr’e falls, both of which tend to shift the current period IS curve to the right. The direct
effect of the deficit reduction—as a result of an increase in T or a reduction in G—shifts the current
period IS curve to the left. The net effect on output—whether the current period IS curve shifts right or
left—could be positive or negative.
This analysis suggests that a deficit reduction program is less likely to reduce current output to the extent
that it is backloaded, i.e., takes place further in the future, because the direct negative effects on output
(through reduced government spending or increased taxes) are postponed. On the other hand, a
backloaded deficit reduction program may not be credible. People may not believe that the government
will follow through on politically difficult spending reductions and tax increases promised in the future.
A box in the text discusses Ireland’s two attempts at deficit reduction in the 1980s. The first, in the early
part of the decade, was associated with low growth and an increase in the unemployment rate. The
second, in the latter half of the decade, was associated with high growth and a reduction in the
unemployment rate. Some economists have argued that the second deficit reduction, which focused on
spending cuts and tax reform, provides an example of an expansionary deficit reduction. They argue that
the first deficit reduction, which focused on tax increases and did not change the size of the government’s
role in the economy, did not change expectations about the future very much. The text argues that
evidence on the saving rate is consistent with this story. During the first deficit reduction, the saving rate
rose, which suggests increased pessimism about the future. During the second deficit reduction, the
saving rate fell, which suggests increased optimism about the future. Monetary policy and other
economic factors also differed between the two episodes, however, so the difference in results cannot be
attributed entirely to expectations.
V. PEDAGOGY
The presentation of the effects of expected monetary policy can be aided by drawing two IS–LM
diagrams, one for the present and one for the future. Begin by working out the short-run effects of
expected future monetary policy in the IS–LM diagram representing the future. In the long run, future
monetary policy will be neutral. The (short-run) changes in future output and the future interest rate show
how expected future output and the expected future interest rate change. Use these effects on
expectations to determine the effects on current variables in the IS–LM diagram representing the present.
This technique ignores changes in expected inflation, but it does give a sense of the effects of Fed
watching on the economy.
The use of present and future IS-LM diagrams is less useful for illustrating the effects of expected fiscal
policy, because changes in fiscal policy affect capital accumulation and output in the long run.
VI. EXTENSIONS
The first edition of the text used the Clinton deficit reduction package as an illustration of the design of
deficit reduction programs. One point that emerged from this discussion was that expectations about the
response of the central bank to a deficit reduction program affect the ultimate effect of this policy on
output. Instructors might want to include the potential response of the Federal Reserve in the discussion
of deficit reduction programs.
©2017 Pearson Education, Inc. Publishing as Prentice Hall
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