Economics – Mr. Graboski 10/3/11 Do Now: If the American economy is in a downward spiral, should the federal government step in with increased spending to help the economy recover? Please give two reason why or why not:

Economic Theory Classical Theory (Adam Smith) Publishes his major work, The Wealth of Nations in Smith argues that the key to a healthy economy is competition. The father of modern economics. The concept of the “invisible hand”

Classical Economics Focuses on the decisions of producers and consumers in a free market. Supply and demand will regulate the economy. Given time, even in times of economic turmoil, the free market would adjust and return to equilibrium. Classical economists believe that the government’s role in the economy should be minimal. In their view every dollar spent by gov’t is one less dollar spent by producers/consumers to stimulate economic activity.

Classical Economics Major belief is in having a balanced budget. They argue that running a budget deficit is one of the worst things a country can do. They do not advocate deficit spending.

Keynesian Economics John Maynard Keynes: His seminal work was title The General Theory of Employment, Interest, and Money. His ideas are revolutionary. They come to have a great influence on early 20 th century political leaders, and continue today (Obama)

Keynesian Economics Gave new ideas on how to break out of a recession/depression. He argued that the major problem during a recession is suppressed demand. Workers are laid off, overall demand for goods and services drops. Keynes believed the fastest way to break this downward spiral was for political leaders to use fiscal policy to increase overall demand.

Keynesian Economics What were some of the ideas that Keynes proposed to increase overall demand in an economy?

Keynesian Economics Increased demand can be brought about in two ways: cutting taxes or by boosting government spending. The radical new idea Keynes proposes is that to be effective, increased government spending should be financed by borrowing money rather than by raising taxes. Higher taxes would only take more money away from consumers.

Keynesian Economics The Keynesian school of thought holds that government intervention in the economy is the best way to ensure economic stability. If total spending by consumers and businesses is not enough to stimulate growth, then the gov’t should step in to increase demand. Rising demand stimulates the need for more goods and services=the need for increased production puts more people back to work. And the economy will continue to grow.

Keynesian Economics When an economy recovered, tax collections would then rise. The government would eventually run a surplus, and the debt could be paid back. The justification for temporary federal deficits was one of the lasting contributions of Keynesian economics. Revolutionary for the time period.

Keynesian Economics Keynes rejected the view of classical economists who believed that in the long run the Great Depression would run its course and the economy would grow. “This long run is a misleading guide to current affairs. In the long run we are all dead.” In 1934 Keynes advises FDR to increase deficit spending: when the government spends more money than it collects in revenue.

Federal Spending Mandatory Spending: Required by law to spend a certain amount of money on these programs. The two types of mandatory spending are interest on the national debt and entitlements. Entitlement programs: Social Security, Medicare, Welfare, Veterans Pensions, UI, and Food Stamps. The % of federal revenue spent on entitlement programs has increased significantly in recent decades. 33% in 1962, 65% in 2010 (Why?) The only way to change the amount spent on these programs is with new legislation.

Federal Spending Entitlements: The availability of these programs is a guarantee that economic instability or some other factor will not cause demand to fall below a certain level for selected individuals.

Federal Spending Discretionary spending: The amount spent here can be raised or lowered as Congress sees fit. It is only a matter of enacting and passing the changes to the federal budget. Defense spending accounts for 53 % of discretionary spending. Smaller amounts for education, scientific research, transportation, and foreign aid.

Multiplier Effect Each dollar spent by government encourages still more spending by consumers. Sending a ripple of economic activity through the economy. Ultimately it benefits a wider circle of people.