Chapter 11

 Explain the Keynesian view of fiscal policy  Understand how fiscal policy affects the economy.  Evaluate the effectiveness of fiscal policy.

 Fiscal Policy ◦ Changing taxes or government spending with the purpose of achieving macroeconomic goals ◦ Conducted by Congress and the President

 Classical view was mainstream  Thought recovery from recessions would ◦ Occur without fiscal policy ◦ Happen quickly  Economy can self-heal

 GDP fell over 30% from  Unemployment ◦ 25% in 1933 ◦ 17% in 1939  Per capita income fell 10%

 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

 Total spending = current output  Changes in output direct economy  Small changes in spending have a BIG impact

 Multiplier principle ◦ One individual’s expenditures becomes the income of another ◦ Small disruptions quickly become recessions

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

 The expenditure multiplier indicates how much additional income will be created by $1 of additional spending  Expenditure multiplier theory implies spending is always awesome!

 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?

 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

 Classical: Equilibrium Classical EconomicsKeynesian 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 FlexibleVery sticky downward Federal Budgets Should always be balanced Should run deficit during recession and surplus during expansion Interest Rates FlexibleCuts 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

 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

Price Level LRAS Goods and Services (real GDP) AD 1 YFYF e1e1 P1P1 Y1Y1 SRAS 1

Price Level LRAS Goods and Services (real GDP) AD 1 YFYF e1e1 P1P1 Y1Y1 SRAS 1 SRAS 2 E2E2 P2P2

Price Level LRAS Goods and Services (real GDP) AD 1 YFYF e1e1 P1P1 Y1Y1 SRAS 1 P2P2 E2E2 AD 2

When the economy is operating below potential output, use expansionary fiscal policy

 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)

Price Level LRAS Goods and Services (real GDP) YFYF e1e1 P1P1 SRAS 1 AD 1 Y2Y2

Price Level LRAS Goods and Services (real GDP) YFYF e1e1 P1P1 SRAS 1 AD 1 Y2Y2 SRAS 2 P2P2 E2E2

Price Level LRAS Goods and Services (real GDP) YFYF e1e1 P1P1 SRAS 1 AD 1 Y2Y2 AD 2 E2E2 P2P2

When the economy is experiencing inflation, use restrictive fiscal policy

 Spending is popular! It makes political sense!

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

 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!

 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

 Explain the Keynesian view of fiscal policy  Understand how fiscal policy affects the economy.  Evaluate the effectiveness of fiscal policy.