Deficit Financing Strategies and the Fiscal Multiplier

Abstract

A significant proportion of the recent literature on various macroeconomic policy issues bases the analysis on models which possess precise microeconomic foundations. This is mainly motivated by the ability of such models to allow for the structure of preferences, technologies and market imperfections to be taken into account explicitly (see the reference list for a sample of studies within this category). These studies usually assume that the economy consists of three types of agents: households who consume, save and supply labour; firms which demand labour and supply a homogeneous consumption good; and a government which has real expenditure plans financed by taxation, borrowing and/or issuing money. The typical model assumes that the three agents described above engage in transactions in four markets: goods, labour, money and bonds (the last two issued by the government). The corresponding demand and supply equations are derived from some optimising behaviour and a general equilibrium model is constructed by setting demand equal to the corresponding supply and taking account of the relevant budget constraints which imply some adding up restrictions. The model is then solved to determine the endogenous variables in terms of the exogenous ones and the solution is used to obtain some policy implications regarding, for instance, the effect of a fiscal expansion. This paper looks at the structure of such general equilibrium models and argues that the effect of a fiscal expansion is sensitive to the way the model is set up.