Anticipated Fiscal Policy Changes and Goods Market Adjustments

Abstract

Abstract Government policies are frequently known to be temporary and thus their termination is perfectly anticipated. These foreseen policy changes must be consistent with equilibrium in both the goods market and asset markets. Potential problems arise because prices often play dual roles, both as final goods prices, and as asset prices, as components of rates of return. We show how the economy accommodates an anticipated policy change depends upon its production flexibility and its structure. With flexible investment, an anticipated reduction in government expenditure is fully accommodated by capital accumulation. When investment involves adjustment costs, the marginal utility of wealth and the price of capital both jump so as to maintain equality among rates of return. Goods market clearance is maintained by a combination of increases in consumption and investment. Extensions of the model to include inventories and to a small open economy are also considered and contrasted.