Fiscal policy and the macroeconomy : some common misconceptions and a reassessment

This paper presents a critique of the traditional textbook representation of fiscal policy, and highlights the misleading policy implications perpetuated by this analysis. In particular, the conclusion that fiscal deficits are likely to be associated with higher interest rates is disputed, as is the associated inference that fiscal policy is relatively ineffective in the case of an open economy with flexible exchange rates and a high degree of international capital mobility. These conclusions are shown to depend critically on representations of money and government finance that bear little resemblance to those found in modern capitalist economies, where money supply is determined endogenously and central banks target short term cash rates as monetary policy instruments. The traditional textbook models are reconfigured to incorporate these features, so as to suggest more fruitful approaches to thinking about the formulation and effectiveness of fiscal policy beyond the confines of the textbook models.