Fiscal Policy: The Keynesian View and

Historical PerspectiveChapter 11

Explain the Keynesian view of fiscal policy Understand how fiscal policy affects the

economy. Evaluate the effectiveness of fiscal policy.

Chapter 11 Objectives

Fiscal Policy◦ Changing taxes or government spending with the

purpose of achieving macroeconomic goals ◦ Conducted by Congress and the President

Held Constant in Ch 9 and 10

Classical view was mainstream Thought recovery from recessions would

◦ Occur without fiscal policy◦ Happen quickly

Economy can self-heal

Before Great Depression

GDP fell over 30% from 1929 - 1933 Unemployment

◦ 25% in 1933◦ 17% in 1939

Per capita income fell 10%

Great Depression: 1929 - 1939

Keynes Disagrees w/ classical

economists Resource prices sticky

downward◦ Unions◦ Large corporations

Pessimism: can get stuck in recession

Increase in consumer spending ◦ Firms sell more goods ◦ Firms produce more goods

As long spending remains strong, boom continues

Decrease in consumer spending ◦ Firms sell fewer goods ◦ Firms make fewer goods

As long as spending remains weak, recession continues

Keynesian Equilibrium

Total spending = current output Changes in output direct economy

Small changes in spending have a BIG impact

Keynesian Equilibrium

Multiplier principle◦ One individual’s expenditures becomes the

income of another◦ Small disruptions quickly become recessions

Keynes’ Expenditure Multiplier

Marginal propensity to consume – the proportion of additional income that households choose to spend on consumption

Keynes’ Expenditure Multiplier

Keynes’ Expenditure Multiplier

MPCreMultiplieExpenditur

1

1

The expenditure multiplier indicates how much additional income will be created by $1 of additional spending

Expenditure multiplier theory implies spending is always awesome!

Keynes’ Expenditure Multiplier According to the multiplier principle, how

much additional income will be generated if the MPC is 0.75 and Congress passes a $1 million stimulus bill?

What if the MPC is 0.9?

Answers: $4 million and $10 million

Assumes that all workers impacted by new spending were initially unemployed!

Reality: ◦ More spending just leads to higher prices if

resources were already in use◦ The multiplier will have it’s biggest impact if

resources were unemployed ◦ What is the opportunity cost of Congress’s

stimulus spending?

Keynes’ Expenditure Multiplier

Paradox of thrift – the idea that when many households try to increase saving, actual saving may not increase

Reality: uncontrolled spending beyond your means isn’t good!

Saving is the source of investment capital◦ More saving higher growth of GDP◦ More saving greater future GDP

Keynes’ Expenditure Multiplier

Classical: Equilibrium

Classical Economics

Keynesian Economics

Recessions Mild and relatively short; infrequent

Unnecessarily painful and long

Self-Correction

Takes place over a few months

Nearly impossible

Recovery Occurs automatically as resource prices adjust

Cannot occur automatically

Resource Prices

Flexible Very sticky downward

FederalBudgets

Should always be balanced

Should run deficit during recession and surplus during expansion

Interest Rates

Flexible Cuts by Fed will not stimulate spending

Equilibrium Expected price level = actual price level

Total spending = current output

Congress and the president should pursue countercyclical policy that attempts to move the economy in an opposite direction from the forces of the business cycle

Keynesian Economics

Keynesian Economics

During a recession, the government should Cut taxes and/or increase government

spending This means running a budget deficit

Keynes said this will stimulate AD and shift it right

Recession

Price LevelLRAS

Goods and Services (real GDP)

AD1

YF

e1P1

Y1

SRAS1

Classical Economists: Economy will self- correct when resource prices fall

Price LevelLRAS

Goods and Services (real GDP)

AD1

YF

e1P1

Y1

SRAS1

SRAS2

E2P2

Keynesian Economists: Expansionary fiscal policy must be used to fight unemployment

Price LevelLRAS

Goods and Services (real GDP)

AD1

YF

e1P1

Y1

SRAS1

P2 E2

AD2

Expansionary Fiscal Policy

When the economy is operating below potential output, use expansionary

fiscal policy

Keynesian Economics What your politicians won’t tell you

During a boom, the government should Increase taxes and/or cut government

spending This means running a budget surplus

Keynes said this will dampen AD and shift it left (mitigating inflation)

Inflationary Boom

Price LevelLRAS

Goods and Services (real GDP)YF

e1P1

SRAS1

AD1

Y2

Classical Economists: Economy will self- correct when resource prices rise

Price LevelLRAS

Goods and Services (real GDP)YF

e1P1

SRAS1

AD1

Y2

SRAS2

P2 E2

Keynesian Economists: Restrictive fiscal policy must be used to fight inflation

Price LevelLRAS

Goods and Services (real GDP)YF

e1P1

SRAS1

AD1

Y2

AD2

E2P2

Restrictive Fiscal Policy

When the economy is experiencing inflation, use

restrictive fiscal policy

Spending is popular! It makes political sense!

Keynesian Economics What your politicians won’t tell you

You ever hear of someone running on a restrictive fiscal policy platform?

Keynesian Economics What your politicians won’t tell you

Policy lags◦ Political process moves slowly (6 – 12 months)

◦ Policy takes time to impact economy (6 – 12 months)

Difficult to predict future economic conditions

Incorrect policy timing would create economic instability, not fix it!

Timing of Fiscal Policy

Automatic stabilizers – ◦ Tend to lead to a budget deficit during a recession

and a surplus during a boom, ◦ Do not require a change in policy

Examples◦ Unemployment compensation◦ Corporate profit tax◦ Progressive income tax

Automatic Stabilizers

Explain the Keynesian view of fiscal policy Understand how fiscal policy affects the

economy. Evaluate the effectiveness of fiscal policy.

Chapter 11 Objectives