Fiscal Policy and Keynesians

John Maynard Keynes

John Maynard Keynes, (June 5, 1883 –

April 21, 1946) was a British economist

whose ideas had a major impact on

modern economic and political theory as

well as on many governments' fiscal

policies.

He is particularly remembered for

advocating interventionist government

policy, by which the government would

use fiscal and monetary measures to aim

to mitigate the adverse effects of

economic recessions, depressions and

booms. Economists consider him one of

the main founders of modern theoretical

macroeconomics. His popular expression

"In the long run we are all dead" is still

quoted.

Discretionary Fiscal Policy

Discretionary Fiscal Policy

The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance

Discretionary Fiscal Policy

(cont'd)

Fiscal Policy

The discretionary changing of government expenditures or

taxes to achieve national economic goals, such as high

employment with price stability

Discretionary Fiscal Policy

(cont'd)

An increase in government spending will stimulate

economic activity

Changes in government spending

Military spending

Education spending

Budgets for government agencies

Figure 13-1 Expansionary and

Contractionary Fiscal Policy:

Changes in Government Spending,

Panel (a)

If there is a recessionary gap

in panel (a), fiscal policy can

presumably increase

aggregate demand

Figure 13-1 Expansionary and

Contractionary Fiscal Policy:

Changes in Government Spending,

Panel (b)

If there is an inflationary gap,

fiscal policy can presumably

decrease aggregate demand

Figure 13-2 Contractionary and

Expansionary Fiscal Policy: Changes

in Taxes, Panel (a)• In panel (a), the economy is

initially at E1, where real GDP

exceeds long-run equilibrium

• Contractionary fiscal policy can

move aggregate demand to

AD2 via a tax increase

• A new equilibrium is at E2 at a

lower price level

• Real GDP is now consistent

with LRAS

Figure 13-2 Contractionary and

Expansionary Fiscal Policy: Changes

in Taxes, Panel (b)• In panel (b) with a

recessionary gap (in this case

$500 billion) taxes are cut

• AD1 moves to AD2

• The economy moves from E1

to E2, and real GDP is now at

$12 trillion per year

• We are at the long-run

equilibrium level

Discretionary Fiscal Policy

(cont'd)

Change in taxes

A rise in taxes causes a reduction in aggregate demand

because it can reduce consumption spending, investment

expenditures, and net exports.

Possible Offsets to Fiscal Policy

Fiscal policy does not operate in a vacuum and important questions must be answered.

How are expenditures financed and by whom?

If taxes are increased what does government do with the taxes?

What will happen if individuals worry about increases in future taxes?

Possible Offsets

to Fiscal Policy (cont'd)

Crowding-Out Effect

The tendency of expansionary fiscal policy to cause a

decrease in planned investment or planned consumption in

the private sector; this decrease normally results from the

rise of interest rates.

The Crowding-Out Effect,

Step by Step

The Crowding-Out Effect

Expansionary policy causing

deficit spending initially shifts

from AD1 to AD2

Due to crowding out,

AD shifts inward to AD3

Equilibrium GDP

below full-employment

GDP—recessionary gap

Possible Offsets to Fiscal Policy (cont'd)

Planning for the future:

the Ricardian equivalence theorem

Ricardian Equivalence Theorem

The proposition that an increase in the government budget deficit has no effect on

aggregate demand

The reason for the offset

People anticipate that a larger deficit today will mean higher taxes in the future and

adjust their spending accordingly.

Possible Offsets

to Fiscal Policy (cont'd)

Direct Expenditure Offsets

Actions on the part of the private sector in spending

income that offset government fiscal policy actions

Any increase in government spending

in an area that competes with the

private sector will have some direct expenditure offset.

Possible Offsets

to Fiscal Policy (cont'd)

The supply-side effects of changes in taxes

Expansionary fiscal policy could involve reducing marginal tax rates.

Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.

The increased productivity will lead to more economic growth.

Possible Offsets

to Fiscal Policy (cont'd)

Supply-Side Economics

The suggestion that creating incentives for individuals and

firms to increase productivity will cause the aggregate

supply curve to shift outward

Laffer CurveKhaldun-Laffer curve is a representation of the relationship

between possible rates of taxation and the resulting levels of

government revenue.Tax rates and

tax revenues

rise together

Tax revenues

are at a maximum

Tax rates and tax

revenues fall

together

Discretionary Fiscal Policy in Practice:

Coping with Time Lags

Recognition Time Lag

The time required to gather information about the current state of the economy

Action Time Lag

The time required between recognizing an economic problem and putting policy into

effect

Effect Time Lag

The time it takes for a fiscal policy to affect

the economy

Discretionary Fiscal Policy in Practice:

Coping with Time Lags (cont'd)

Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation.

Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.

Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

Automatic Stabilizers

Automatic or Built-In Stabilizers

Changes in government spending and taxation that occur

automatically without deliberate action of Congress

The tax system

Unemployment compensation

Welfare spending

Automatic Stabilizers

The automatic changes

tend to drive the economy

back toward its full-

employment output level

What Do We Really Know

About Fiscal Policy?

Fiscal policy during normal times

Congress ends up doing too little too late to help in a

minor recession.

Fiscal policy that generates repeated

tax changes (as has happened)

creates uncertainty.

What Do We Really Know

About Fiscal Policy? (cont'd)

Fiscal policy during abnormal times

Fiscal policy can be effective

The Great Depression—fiscal policy may be able to stimulate

aggregate demand.

Wartime—during World War II real GDP increased dramatically.

What Do We Really Know

About Fiscal Policy? (cont'd)

The “soothing” effect of Keynesian fiscal policy

Should we encounter a severe downturn, fiscal policy is

available.

Knowing this may reassure consumers

and investors.

Stable expectations encourage a smoothing of investment

spending.