the markets. The fear is that, should a serious recession hit Europe, governments would not have the possibility to use the fiscal instrument to practice 'coarse-tuning' policies, in Lindbeck's phrase. In this regard, students are invited to analyse the different interpretation of Maastricht criteria given by France and Germany.
Q3 The government plans a reduction in income taxes, to be financed by borrowing, with the aim of increasing demand to stimulate the economy. Discuss this policy proposal. In your reply, comment on the perspective of Ricardian equivalence proponents on such a proposal.
This is a typical expansionary policy and the effect depends on the time horizon under consideration and on the expectations of investors and financial markets. The rationale behind this proposal is represented in figure 15.1 and corresponds to the Keynesian idea of fiscal policy management. A decrease in taxes augments disposable income of households: more money is spent in consumption and investment goods, stimulating the economy and cutting unemployment. In Keynesian terms, the aggregate supply curve is horizontal until the point of full employment. A decrease in taxes implies a shift outwards of the AD curve, increasing output and employment through the fiscal multiplier (in figure 15.1, AD moves to AD' increasing output from Y0 to Y1).
This positive effect is counterbalanced by other negative effects: if the reduction in taxes is financed by borrowing, the excess of money demand leads to an increase in the interest rate with adverse effects on investment and consumption. The AD curve, because of the reduction in investment and consumption, moves leftwards. According to Keynesian economics, this crowding out in private expenditure is only partial (AD' moves to AD'' and the final equilibrium is in Y2) but it is complete according to classical economics (AD' moves back to AD and the equilibrium remains in Y0), thus rendering fiscal expansion policies ineffective.
While this analysis refers mainly to the short term, more important is the effect of fiscal expansion in the long term, which is linked to the issue of sustainability of fiscal deficits. While Keynesian economics seems to work in the short and in the medium-long term (after all, expansionary fiscal policies have provided Europe with full employment and higher standard of living since the end of World War II until the 1970s), its analysis of affordability in the long run has proved wrong. Keynesians thought that fiscal expansion could be financed largely, and perhaps entirely, through an increase in taxation revenue obtained from higher output.
Empirical evidence reveals instead that, because of continuos borrowing, the burden of public debt has grown. In the long run, the unsustainability of the debt creates further costs. The loss of credibility in the ability of a country to reduce the debt leads to a rise in the interest rate: the interest repayment becomes the most important part of a country's deficit and the government has to borrow just to pay interest on previous debt.
The solution to this spiral is twofold: either taxes have to be raised in order to achieve a balance in public accounts, or expenditure has to be curbed. Both instruments imply a movement inwards of the AD curve, crowding out the previous gains from expansionary policies. However, these contractionary policies can be expansionary if better expectations on the future level of the interest rate stimulate private spending (see