Chapter 26 discusses the instruments and impact of fiscal policy. The discussion of credible deficit reduction plans below looks at a plan aimed at lessening the short-run impact of budget deficit reductions on the economy.

Because of the harmful long-term effects of the deficit, many economists feel that lowering the deficit is a good idea. But just as an increase in the deficit can raise real GDP in the short run, a decrease in the deficit can reduce real GDP below potential GDP in the short run. Thus, even though there is a long-term benefit from deficit reduction, there is possible short-term harm. Is there any way this harm can be reduced?

In recent years economists have searched for ways to lessen the short-run impact of the budget deficit reductions on the economy. The idea of rational expectations has helped in the search. The idea of rational expectations is that people, like economic forecasters, try to figure out what government actions will be. People also take these expectations of government actions into account in their personal decisions. Government policymakers have credibility if their announcements about future government actions are believable to people. If people’s expectations are rational, then credibility can greatly influence how a change in the budget deficit affects the economy.

For example, if the government announces in advance its intention to reduce the deficit over a number of years in the future, and if the government’s announcement is credible, then the negative short-run impact of the deficit reduction on the economy might be greatly reduced. Why?

We know that in the long run, the reduction in the budget deficit will lower interest rates. Thus, if the government announces plans to reduce the budget deficit in the future, people will expect that interest rates will decline in the future; this expectation of a future decline in interest rates may lower current interest rates.

Interest Rates and Expectations.

Expectations of future declines in interest rates lower current interest rates because people have a choice between buying long-term bonds and short-term bonds. Consider the choice between a longer-term government bond with a maturity of 2 years and a shorter-term government bond that lasts 1 year. The choice is shown in Table 29.4.

The table below shows the average interest rate for two alternatives: When you are deciding to buy the 2-year bond, your alternative is to buy the short-term bond. Rather than a 2-year bond, you could buy a 1-year bond and then buy another 1-year bond next year. The average interest rate over the two-year period should be about the same as the interest rate on the 2-year bond. Otherwise, no one would buy the bond with the lower average interest rate. If you expect interest rates to rise sharply next year, you will not buy the 2-year bond unless the current interest rate is higher. The interest rates on long-term bonds are thus affected by expectations of future interest rates. If people expect future interest rates to rise, then the interest rates on long-term bonds rise. If people expect future interest rates to fall, then interest rates on long-term bonds fall. The same analysis applies to 5-, 10-, or even 30-year bonds as well as to 2-year bonds.

Effect of a Change in Expected Future Interest Rates

• A 2-year bond is held for 2 years and pays the current long-term interest rate of R percent each year.
• A 1-year bond is held for 1 year and pays the current short-term interest rate of 5 percent; another 1-year bond is bought at the end of the first year with an expected interest rate of r percent.

Type of Bond	Interest Rate in First Year	Interest Rate in Second Year	Average Interest Rate
Long term (2 years)	R	R	R
Short term (1 year)	5	r	5+r 2

The average interest rate should be the same on the two so that R = (5+r)/2. Thus, if the expected future short-term interest rate ® rises, so does the current long-term interest rate (R).

Now, suppose that the government announces a credible deficit reduction plan to take place over a 10-year period. People who buy and sell bonds will reason that future short-term interest rates will be lower as a result of the lower budget deficit. If they expect future interest rates to be lower, then the current long-term interest rate on bonds will decline. Now, long-term interest rates as well as short-term interest rates affect investment decisions. Hence, the lower long-term interest rates will reduce borrowing costs, and firms will begin to invest more. Note that the increase in investment is occurring in the short run, not only in the medium run and the long run, because interest rates have declined in the short run.

In the ideal case, the increased investment and net exports would just offset the decline in government purchases in the short run, and there would be no negative effect on real GDP. However, the ideal case is very hard to realize because it depends on the government announcements being very credible and on people adjusting their expectations to take account of the announcements. Moreover, the speed by which firms increase their investment must exactly match the speed of reduction in government purchases. Also, even if real GDP is unaffected, there may be different effects in different regions of the country because the lower government purchases and the increased investment would not necessarily occur in the same place.