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Government deficit and “The World’s smallest macroeconomic model” by Paul Krugman

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  • Yasuhito Tanaka

    (Faculty of Economics, Doshisha University, Kyoto, Japan)

Abstract

In his "The World’s smallest macroeconomic model” (Krugman (1999)), Paul Krugman argued that under the assumption of price rigidity, a shortage of money supply leads to underemployment or recession, so increasing money supply can eliminate underemployment and restore full employment. But, how do we increase the money supply? I will show that we need a government deficit to increase the money supply in order to restore full employment from recession. Also, I will show that in a growing economy, if people hold money, a government deficit is necessary to maintain full employment under constant price or inflation. A government deficit is not only effective in pulling the economy out of recession, it is even necessary for continued growth without inviting either recession or inflation. The government deficit in this paper represents the difference between government expenditures and government revenues. When the difference is positive, we say that the government has a deficit. This paper seeks to explore theoretically and normatively the role of government deficits in achieving and maintaining full employment in a growing economy without causing inflation, using a very simple model by Krugman.

Suggested Citation

  • Yasuhito Tanaka, 2023. "Government deficit and “The World’s smallest macroeconomic model” by Paul Krugman," Financial Economics Letters, Anser Press, vol. 2(1), pages 44-53, September.
    • Handle: RePEc:bba:j00007:v:2:y:2023:i:1:p:44-53:d:208
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    References listed on IDEAS

    as
    1. Mathew Forstater, 1999. "Functional Finance and Full Employment: Lessons from Lerner for Today," Macroeconomics 9908002, University Library of Munich, Germany.
    2. Raurich, Xavier & Sala, Hector & Sorolla, Valeri, 2006. "Unemployment, Growth, And Fiscal Policy: New Insights On The Hysteresis Hypothesis," Macroeconomic Dynamics, Cambridge University Press, vol. 10(3), pages 285-316, June.
    3. Ono, Yoshiyasu, 2001. "A Reinterpretation of Chapter 17 of Keynes's General Theory: Effective Demand Shortage under Dynamic Optimization," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(1), pages 207-236, February.
    4. Mathew Forstater, 1999. "Functional Finance and Full Employment: Lessons from Lerner for Today," Journal of Economic Issues, Taylor & Francis Journals, vol. 33(2), pages 475-482, June.
    5. Mathew Forstater, 1999. "Functional Finance and Full Employment: Lessons from Lerner for Today," Economics Working Paper Archive wp_272, Levy Economics Institute.
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