18.2 Fiscal policy, investment, and economic growth  (Page 3/15)

At this point, you may wonder about the Federal Reserve . After all, can the Federal Reserve not use expansionary monetary policy to reduce interest rates, or in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy    . In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.

On the other hand, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with expansionary monetary policy    . In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.

However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must fall. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.

Public investment in physical capital

Government can invest in physical capital directly: roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, like hydroelectric dams or windmills; telecommunications facilities; and weapons used by the military. In 2014, the U.S. federal government budget for Fiscal Year 2014 shows that the United States spent about $92 billion on transportation, including highways, mass transit, and airports. [link] shows the total outlay for 2014 for major public physical capital investment by the federal government in the United States. Physical capital related to the military or to residences where people live is omitted from this table, because the focus here is on public investments that have a direct effect on raising output in the private sector.

Public physical capital investment of this sort can increase the output and productivity of the economy. An economy with reliable roads and electricity will be able to produce more. But it is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or even go out of business.