Macro Chapter 11

Fiscal Policy: The Keynesian View and Historical Perspective

6 Learning Goals

1) List the key arguments in Keynesian Economics 2) Describe the multiplier process then identify potential problems with the process 3) Define a budget surplus and deficit 4) Differentiate between restrictive and expansionary fiscal policy 5) Explain how fiscal policy is implemented 6) Discover timing issues related to fiscal policy

The Great Depression and the Macroadjustment Process

Watch Video: History Channel FDR depression and 1932 election

John M. Keynes

Incredibly influential economist Major points of thinking: 1. Resource prices and interest rates are not very flexible so they won’t direct an economy to equilibrium 2. Changes in output will direct an economy to equilibrium

John M. Keynes

1935, about his forthcoming book

The General Theory of Employment, Interest and Money

“I believe myself to be writing a book on economic theory which will largely revolutionize not, I suppose, at once but in the course of the next ten years the way the world thinks about economic problems.”

Friedrich Hayek

1944,

The Road to Serfdom

According to the views now dominant, the question is no longer how we can make the best use of the spontaneous forces found in a free society. We have in effect undertaken to dispense with the forces which produced unforeseen results and to replace the impersonal and anonymous mechanism of the market by collective and "conscious" direction of all social forces to deliberately chosen goals.

Watch Video: Comm Heights 1-Keynes v Hayek

For more about Keynes & Hayek:

See Optional Video Free to Choose (FTC) Keynesian economics If you really want details, see optional videos Commanding Heights 1, Chapters 1 through 8 For fun, check on the two videos “Fear the Boom and Bust” and “Fight of the Century” (lyrics also provided)

The Solution?

Y = C + I + G + X If C, I, and X are stagnant or declining, increase G After the multiplier kicks in, C, I, and X will increase AD shifts right until full employment is reached

This is not ancient economic theory

President Obama in February, 2009 Watch Video: Obama-only government can break cycle

Q11.1 A hail storm that breaks lots of windows in buildings is 1. good for the economy because the spending on repairs will expand net employment.

2. good for the economy because spending on the repairs will drive up the general level of prices.

3. bad for the economy because the damage from the storm will be subtracted from this year’s GDP.

4. bad for the economy because wealth was destroyed and more spending on repairs will result in less spending on other goods and services.

What are some problems associated with the multiplier?

Watch Video: Stossel Macro 04 Gov’t spending, jobs, and unemployment

Q11.2 Within the Keynesian model, the multiplier effect tends to 1. smooth out the up- and down- swings of the business cycle.

2. promote price stability.

3. magnify small changes in spending into much larger changes in output and employment.

4. reduce the impact of an increase in investment on output and employment.

Key Points:

The multiplier “works” with an increase in C, I, G, or X The multiplier is more potent when 1. Unemployment is unusually high 2. There is an increase in C, I, or X The multiplier is less potent when 1. Unemployment is closer to natural rate 2. There is an increase in G (because of secondary effects)

Note:

You do not need to remember the formula for the multiplier No quiz or exam questions will ask you to calculate the multiplier or know the relationship between MPC and M

The Keynesian View of Fiscal Policy

What is fiscal policy?

Fiscal policy is simply the tools used by Congress and the President to alter economic activity Primary tools are government spending and taxes

Fiscal Policy and the Good News of Keynesian Economics

How does fiscal policy work?

Increase gov’t spending and/or decrease taxes – Expansionary- try to increase AD Decrease gov’t spending and/or increase taxes – Restrictive- try to decrease AD

Q11.3 According to Keynesian theory, which of the following would most likely stimulate an expansion in real output if the economy were in a recession?

1. an increase in tax rates 2. a balanced budget 3. a budget deficit 4. a budget surplus

Q11.4 The government is pursuing an expansionary fiscal policy if it 1. decreases government spending and/or increases taxes.

2. increases government spending and/or increases taxes.

3. decreases government spending and/or reduces taxes.

4. increases government spending and/or reduces taxes.

What are some common problems of fiscal policy?

Even if you believe fiscal policy works, there are still some potential problems

Let’s say we want to “fix” the economy. What problems might we encounter?

First, we have a recognition lag Second, we have an implementation lag Third, we have an effectiveness lag

Note:

You do not need to know the details of automatic stabilizers

11.1 = 4 11.2 = 3 11.3 = 3 11.4 = 4

Question Answers: