Chapter 17 The macroeconomics of government finance

This chapter is a critical survey of literature on the implications of government financial policy for economic activity. The central question is whether the mode of financing of a given path of real government purchases — by taxes, non-monetary debt issue, or money creation — has real effects, in particular real effects of macroeconomic consequence. In Section 1, the Introduction, we define the issues with greater detail and precision. We briefly review economists' views, over the past fifty years, of the burden of public debt and the neutrality of money. Section 2 is a review of the 1960s vintage mainstream macroeconomics of fiscal and monetary policies, often called the “neoclassical synthesis”. We review its implications for both short-run fluctuations and long-run trends. We include this review because the earlier tradition covers some problems and issues now neglected, because its analyses and results may still have some validity, and because they did set the stage for — one might say they provoked or inspired — the recent literature surveyed in Sections 4–6. The earlier tradition and the recent literature differ in methodology, and in Section 3 we discuss the “microfoundations” methodology that dominates contemporary macroeconomics. Sections 4–6 are a selective critical survey of recent contributions, theoretical and empirical, designed to summarize the current state of play on the central issues: Section 4, the debt neutrality hypothesis of Robert Barro; Section 5, the effects of financing government expenditures by printing money rather than taxing, monetary superneutrality, and the “Fisher effect” of inflation on interest rates; Section 6, open market operations, and shifts between bond- and money-financing of government expenditures induced by the adoption of financial policies which are unsustainable over the longer run. In each section we first set forth the neutrality theorems purporting to show the irrelevance of the financing choice. Then we discuss articles elaborating or criticizing the theorems. In each case we conclude with a review and evaluation of some empirical tests. We conclude in Section 7 with short summary remarks.