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This paper investigates the effect of a pay-as-you-go, balanced budget policy on macroeconomic performance. It uses a simple model of the aggregate demand for money and goods, with temporary monetary equilibrium and quantity adjustments on goods markets. Within this framework, if the monetary/real interaction is strong enough, a balanced budget with sufficiently high tax rates (== sufficiently high government expenditures) is consistent with typical bounded fluctuations around a relatively high income, low unemployment equilibrium. Lower tax rates (== lower government expenditures) can trigger a sharp decline in revenues, expenditures, employment, and output.
1. INTRODUCTION
Economic rhetoric often contributes little to an understanding of economic process and has even less to do with the facts. Nowhere is this disparity more evident than in contemporary discussions of budget balancing and its effects on the economy. Political commentators as well as some economists often speak as if the government budget directly determines the deficit. People often say that cutting the deficit requires cutting the government budget without recognizing the role of government spending in generating income and tax revenues. The fact is that the government controls its expenditure and tax rates; it does not directly control its revenue. That depends on aggregate income. This situation is perfectly analogous to business firms that determine how much they spend on inputs and what prices they charge for goods. They must await their sales, however, before the profit or loss is known. Because there is a business cycle and because it is highly irregular, the revenue of governments-just like that of businesses-is highly variable and irregular, and, as a corollary, so are deficits.
Day (1994) reexamines fiscal policy using the dynamic, nonlinear, real/monetary macroeconomic model developed in Day and Shafer (1986) and Day and Lin (1991), which takes these facts into account. When the interaction between money and goods markets is strong enough, this model provides an intrinsic explanation of irregular business fluctuations somewhat like the ones experienced in the 1970s and 1980s. Using this framework, one can show that conventional fiscal policy has complicated ramifications within this framework that do not seem to have been recognized previously. In particular, the following conclusions hold for any fixed level of government spending: (i) A deficit reduction policy based on tax increases...