ABSTRACT
Does the effectiveness of fiscal policy in stabilizing an economy depend on the underlying economic context in which the policy is implemented? The answer to such a broad question must certainly be yes, but I argue in this chapter that the answer differs across various dimensions of “context,” three of which are considered here. First, I consider in some detail the most obvious context: the state of economic activity relative to some measure of the economy's potential. I discuss logic and evidence that implies that the presence or absence of idle resources is the key context for fiscal policy. Second, I explore whether the openness of the economy matters, especially the extent to which fiscal stimulus flows abroad by boosting imports or is financed by borrowing from abroad. While this dimension will likely affect the quantitative stimulus that a country gets from fiscal expansion, I conclude that the open-economy context is unlikely to affect the decision of a country that borrows in its own currency to undertake fiscal stimulus. Third, I look at how the level of government debt, what is sometimes called the “debt overhang,” matters for the decision to undertake fiscal stimulus. While I accept that government debt can, in principle, be excessive, I discuss why concerns about the current level of debt in developed, sovereign-currency countries are likely exaggerated.
