I understand how monetary policy can be used to heat up an economy by increasing the money supply, but how can a fiscal policy do so? When the government borrows money to increase spending, it is not as if that money would have just been sitting under somebody's mattress; it would have been loaned to some other entity, whose spending of that money (as far as I know) would cause just as much economic activity as if the government spent it. In addition, the government's demand for money would should raise interest rates and/or strengthen the dollar, which is the opposite of what I generally think of when it comes to an "expansionary" policy. Also, while money could be lent by entities in other countries, that money would just have to flow back out in the form of more imports, so domestic AD shouldn't be affected, no?

The only thing I can think of is that the government can spend 100% of the money that it borrows, whereas if that money went into a bank account, a small portion would not be lent out due to reserve requirements; does that make all the difference?

It's been years since I took an econ class, and I know this is 101 stuff, but I can't figure out what I'm missing...


In an open economy, Government might be borrowing money from abroad and so the logic of how that capital might have anyway been employed to a productive end doesn't work out. (Also sale of forex reserves or taking up loans would depreciate domestic currency leading to increased exports and higher AD).

Also, money supply itself doesn't determine the pace or level of economic growth. It is the consumption and Saving patterns that spur demand, leading to the virtuous cycle of increased incomes and investment.

Provided that the C and S patterns are themselves a function of trust and market expectations (especially during times of economic crisis such as recession or slowdown), government through it's expansionary fiscal policy and the popular credence attached to it, incentivise increased activity and growth.

  • $\begingroup$ I'll have to brush up on the C vs. S thing, as in my mental model every dollar saved (minus reserve requirements, at least until recently) is loaned out, and thus spent; I've been 'obsessing' over money supply issues lately, and have thus probably been ignoring other factors. But I'm surprised that taking loans from abroad would depreciate the currency; when more foreign entities provide loans, they need to buy domestic currency to do so, which would increase the demand for that currency, thus strengthening it, no? $\endgroup$ – David Deutsch Apr 16 '17 at 15:54

If we want to assume that fiscal policy is always effective (see disclaimers below), the logic works as follows.

  • The government sends a cheque ("check" in American English) to someone. This creates a new income flow to the recipient.
  • The cheque is cashed, this adds to the money supply, which may also make its way into the government bond market. If 100% of the amount went into the bond market, the cheque is "self-financing."
  • Meanwhile, the recipient presumably spends at least some of the inflow, which increases economic activity relative to the base line of the government not sending the cheque.
  • Interest rates would only move if the central bank raised the policy rate, or if the fiscal action raised term premia. It is difficult to measure such effects.

The disclaimers:

  • The Treasury needs to have an initial cash balance, but this is usually the case. It can restore the cash balance by borrowing from the ultimate holders of the money created by the expenditure. The circular nature of this flow explains how government debt levels have grown in line with the economy.
  • The argument of "Ricardian Equivalence" is that the government is supposed to have to pay back the increased borrowing, and so there is supposed to be a depressive effect on spending. This argument is controversial.
  • Active monetary policy may cancel out the effect of fiscal policy.
  • The nominal income flow can presumably raise nominal GDP, but this does ensure that real GDP rises.
  • $\begingroup$ Right, but when the government sends a check to someone, that money has to come from somewhere. While in the past few years it looks like banks have a lot of excess reserves (due to the Fed paying interest on reserves), in general it is my understanding that they only keep the minimum reserve requirements. So, the money the government spends would have been spent anyway, no? $\endgroup$ – David Deutsch Apr 16 '17 at 15:44
  • $\begingroup$ The government always starts with a posiitve cash balance at the central bank. I have not looked at the American data, but the Canadian government has about $20 billion at any goven time. They write the cheque, draw down the balance, and then recharge it, as I describe above. Over time, they use bond issuance to build up the balance, but that is small relative to the total flow of deficit financing. $\endgroup$ – Brian Romanchuk Apr 16 '17 at 17:51

Since it doesn't change the money supply, how can an “expansionary” fiscal policy alone spur economic growth?

Your short form question assumes that an expansionary fiscal policy does not change money supply, and that simply is not a valid assumption.

Most “expansionary” fiscal policies do change money supply at least in a secular manner. Let's try a few recent examples. After the great recession the Fed not only lowered the prime interest rate and the Federal overnight lending rate to prime borrowers it was a net purchaser of previously let debt instruments like short term notes and it purchased and allowed banks to sell packages of non-performing loans at par. All of these actions were short term increases in the amount of money available for making new loans or meeting the capital requirements (money required to be held in reserve) aka the money supply.

When interest rates decrease certain sectors of the economy that rely on loans for operations like utilities and small businesses are less likely to expand when interest rates increase and increase business risk beyond the likely return on the investment goal of the proposed loan. So lowering interest rates is expansionary because by expanding the supply of low borrowing cost loans to small businesses they are more likely to take new risks and hire new people and buy new supplies and equipment. This is the most common notion of a secular expansionary fiscal policy.

  • $\begingroup$ But what you described is monetary policy, not fiscal policy. I totally get why monetary policy is expansionary, it is fiscal policy's effect the puzzles me. $\endgroup$ – David Deutsch Apr 16 '17 at 15:40

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