1. Taxes, Fiscal, and Monetary Policies
Unit 7 Macroeconomics:
Taxes, Fiscal, and Monetary Policies
Chapters 15.2
Economics
Mr. Biggs

2. Fiscal Policy Options Classical Economics
Classical economics - The idea that free markets can regulate themselves.
Adam Smith proposed the idea of an “invisible hand” and stated that in a free market, people act in their own self-interest which causes prices to rise or fall.
Supply and demand will always return to equilibrium, but the Great Depression highlighted the problem that classical economics did not address how long it would take to reach equilibrium.

3. Keynesian Economics A Broader View John Maynard Keynes developed a new
theory of economics to explain the Great Depression and give the government a
tool to use in the short run.
A Broader View
Keynes looked at the productive capacity
of the whole economy.
Productive capacity or full-employment output - The maximum output an economy can produce without causing inflation.
He concluded that the only way to end
the Great Depression was if someone
started spending money.

4. A New Role for Government
Keynesian economics - A form of demand-side economics that encourages action to increase or decrease demand and output.
Demand-side economics - The idea that government spending and tax cuts help an economy by raising demand.
Keynes believed that government interventions can make up for economic changes caused by businesses or individuals.
Keynesian economics proposes that by using fiscal policy the government can, and should, help the economy.

5. Avoiding Recessions and Depressions
Keynes argued that fiscal policy can
be used to fight two fundamental macroeconomic problems:
Recession/depression
Inflation
If economic indicators decrease, the government can raise governmental spending and/or cut taxes (expansionary fiscal policies).
Controlling Inflation
Keynes argued that the government could
use contractionary fiscal policies to prevent inflation or reduce its severity.
For example, reducing governmental
spending and/or raising taxes.

6. The Multiplier Effect
Multiplier effect - The idea that every one dollar of government spending creates more than one dollar in economic activity.
For example, if the government
decides to spend money to
stimulate the economy, businesses
would spend their additional
earnings on infrastructure, wages,
raw materials, and investment.
Those recipients will spend a part of
this money, then those recipients
will spend a part of that money, etc.
When all the rounds of spending
are added up, the initial government spending may have a 3-fold increased effect on GDP.

7. Automatic Stabilizers
The use of federal taxes and spending on
transfer payments, two key parts of fiscal policy,
are used to keep the economy stable and are
known as automatic stabilizers.
Automatic stabilizer - A government
program that changes automatically
depending on GDP and a person’s income.
When national income is high, the government
collects more taxes and pays out less in transfer payments (takes money away from consumers).
This decrease in spending balances out the
increase in spending that results from rising income.
The opposite is also true.
When national income is low, the government
collects less in taxes and pays out more in
transfer payments (gives money to consumers).
This increase in spending balances out the decrease
in spending that results from decreasing income.

8. Supply Side Economics The Laffer Curve
Supply side economics - A school of economics that believes tax cuts can help an economy by raising supply.
The Laffer Curve
The Laffer Curve illustrates the relationship between the tax rate set by the government and the total tax revenue that the government collects.
High tax rates may not bring in much revenue if these high tax rates cause economic activity to decrease.
For example, in the extreme case of 100% taxation, no one would want to work.

9. Fiscal Policy in American History
Taxes and Output
Supply-side economists believe that a tax cut increases total employment so much that the government actually collects more in taxes at the new,
lower tax rate.
Historically, taxpayers do not react strongly enough, by working more hours, to tax cuts to increase tax revenue.
Fiscal Policy in American History
President Hoover, influenced by classical economics, thought the economy was sound and would return to equilibrium.
President Roosevelt, influenced by Keynesian economics, was more willing to increase government spending to help lift the economy out of depression.

10. The Kennedy Administration
World War II
Keynesian policies were fully tested in the United States during WWII and proved to be successful.
Council of Economic Advisors (CEA) - A group of three respected economists formed after WWII that advise the President on economic policy.
The Kennedy Administration
President Kennedy inherited a recession when
he took office, so he cut the historically high taxes and over the next two years, the economy grew rapidly as predicted by Keynesian economists.
Supply-Side Policies in the 1980s
President Reagan instituted new policies based on supply-side economics and cut taxes by 25%.
After 1982, the economy recovered and flourished, but the government spent more money than it took in creating large federal deficits.

11. The End