Chapter 12 Government Decisions and Economic Success

What role should the government play in our economy? Classical Economists Classical Economists –Laissiz-faire –Supply and Demand Who, What, How Who, What, How Why might this not work today? Why might this not work today?

Role of Government Free market protection Free market protection –Anti-monopoly Public Goods/Services Public Goods/Services Economic Stability Economic Stability Protection/Sovereignty Protection/Sovereignty Preservation of Rights Preservation of Rights

Disagreements Objectives Objectives Priorities Priorities Poverty vs. Investment? Poverty vs. Investment? Inflation vs. Unemployment? Inflation vs. Unemployment? Free Trade vs. Protectionism? Free Trade vs. Protectionism?

Theories of Govt. Involvement Classical Classical Keynesian Keynesian

The Classical Theory Free-markets correct themselves Free-markets correct themselves –Supply and Demand Wages Wages Prices Prices Interest Rates Interest Rates –Tend towards Full-employment in the long-run Little need for Govt. intervention Little need for Govt. intervention Great Depression challenged this notion Great Depression challenged this notion Micro-economics Micro-economics

Keynesian Theory John Maynard Keynes John Maynard Keynes –Father of Macro-economics Spending drives the economy Spending drives the economy –People –Businesses –Govt. Recessions Recessions –Must rely on Govt. spending –Increase Demand AD= C + I + G + Trade Balance AD= C + I + G + Trade Balance

Keynes (cont.) Key tools (Fiscal policy) Key tools (Fiscal policy) –Taxes –Govt. Spending Recession Recession –Decrease taxes or increase spending Expansion Expansion –Increase taxes or decrease spending “Fine tune the economy” “Fine tune the economy”

Fiscal Policy Taxing and Spending (Congress) Taxing and Spending (Congress) Discretionary Discretionary –Requires action by Congress, President, or agency Automatic Automatic –Doesn’t require new action –Ex. Welfare, Unemployment Benefits, Income taxes

Weaknesses in Keynesian Theory Predicting/Analyzing the economy is hard Predicting/Analyzing the economy is hard Time lags Time lags Inflation vs. Unemployment Dilemma Inflation vs. Unemployment Dilemma –Inflation: Cut spending or increase taxes –Unemployment: Opposite “Crowding-out Effect” “Crowding-out Effect” –Increased spending/borrowing Increases interest rates Increases interest rates Decreases private spending Decreases private spending Inflation without growth in Long Run Inflation without growth in Long Run

Supply-Side Economics Milton Freidman Focusing on shifting supply curve to the right Focusing on shifting supply curve to the right –increase employment –decrease inflation. Decrease Costs of Production Decrease Costs of Production “Trickle Down Theory” “Trickle Down Theory” –Encourages Investment Investment Job creation Job creation Reduced inflation Reduced inflation

Supply-Side Weaknesses Markets don’t always “clear” back to equilibrium Markets don’t always “clear” back to equilibrium –“downward sticky” wages Workers won’t accept lower wages Workers won’t accept lower wages