Chapter 11 Fiscal Policy The Keynesian View and Historical Perspective The Great Depression had a huge impact on modern economics Several of the basic macroeconomic concepts were introduced in the 1930 s The Keynesian model provided an explanation for either unemployment or inflation but it did not account for the simultaneous occurrence of both Prior to the Great Depression economists thought that markets would adjust and direct an economy back to its long run potential rather quickly Keynesian economics provided a reasonable explanation for the prolonged depressed conditions of the 1930 s Keynes believed that spending motivated firms to supply goods and services In the Keynesian view equilibrium takes place when total spending in the economy is equal to current output When this is the case business firms will just be able to sell the quantity of goods and services they are currently producing o Their inventories will neither be rising nor falling therefore would have no reason to expand or contract output Changes in output rather than changes in prices direct the economy toward equilibrium Increase in total spending would generate expanding sales and reduce inventories of firms Businesses would create more output to keep up o Decrease in total spending would lead to a reduction in sales and rising inventories Businesses would cut back on employment and reduce their output to the level of spending The multiplier principle builds on the point that one individual s expenditure becomes the income of another Income recipients will spend a portion of their additional earnings on consumption In turn their consumption expenditures will generate additional income for others who will also spend a portion of it o o If 100 invested results in 400 of additional income the expenditure multiplier would be 4 The total increase in income would be four times the amount of the initial increase in spending cid 2157 cid 2186 cid 2186 cid 2191 cid 2202 cid 2191 cid 2197 cid 2196 cid 2183 cid 2194 cid 2185 cid 2197 cid 2196 cid 2201 cid 2203 cid 2195 cid 2198 cid 2202 cid 2191 cid 2197 cid 2196 cid 2157 cid 2186 cid 2186 cid 2191 cid 2202 cid 2191 cid 2197 cid 2196 cid 2183 cid 2194 cid 2191 cid 2196 cid 2185 cid 2197 cid 2195 cid 2187 o Marginal Propensity to Consume MPC For example if your income increases by 100 and you increase your current consumption expenditures by 75 as a result your marginal propensity to consume is 75 100 75 o Expenditure Multiplier M o Keynesians argue that the multiplier concept indicates that market economies are extremely fragile and that they have a tendency to fluctuate back and forth between excessive and deficient demand cid 2778 cid 2778 cid 2879 cid 2169 cid 2172 cid 2159 If the increase in spending is financed by borrowing there will be upward pressure on real interest rates which will reduce spending in other areas Correspondingly if the additional spending were a result of government project financed by taxes the higher taxes would reduce spending in other areas at least partially offsetting the impact of the multiplier Businesses will produce only the quantity of goods and services they believe consumers investors governments and foreigners will plan to buy If these planned aggregate expenditures are less than the economy s full employment output output will fall short of its potential Moreover reductions in spending will often be amplified by the multiplier and tend to feed on themselves Downturns will breed pessimism among both consumers and investors which will lead to lower prices for assets such as stocks and houses causing total spending and output to plummet downward by even larger amounts When total expenditures aggregate demand on goods and services are deficient market economies do not have an automatic mechanism that will return the economy to full employment Prolonged unemployment will persist Against the backdrop of the Great Depression this was a compelling argument When the supply of money is constant government expenditures must be financed with either o Taxes or revenues derived from other sources o Borrowing Balanced Budget If the government s revenue from taxes and other sources is equal to its total expenditure Budget Deficit When total government spending exceeds total government revenue Budget Surplus When total government spending is less than the total government revenue o Allows the government to reduce its outstanding debt Changes in the size of the deficit or surplus may merely reflect the state of the economy Changes in the deficit or surplus may reflect discretionary fiscal policy o Requires passage of tax and or spending legislation by Congress and the president that alter the size of the budget deficit or surplus An increase in government purchases of goods and services will directly increase aggregate demand o There would be a greater need for the goods and services as the government buys them Changes in tax policy will also influence aggregate demand o A reduction in personal taxes will increase the current disposable income of households As their after tax income rises people will spend more on consumption When an economy is operating below its potential capacity Keynesians believe the Government should institute expansionary fiscal policy o Government should increase its purchases of goods and services cut taxes or both however this increases the government s budget deficit To finance the enlarged deficit the government would have to borrow from private domestic sources or foreigners Restrictive fiscal policy can be used to reduce the aggregate demand as a reduced level of government purchases will diminish aggregate demand directly Higher taxes on households and businesses could be used to dampen consumption and private investment o o e where the tions in aggre cy is not an ea olicy requires Co ountercyclica al policy is on c counter or o offset fluctuat P roper timing of fiscal polic o A chan nge in fiscal p y slowly o A chan nge in policy w change e is adopted impact on the much o Becau se of these de maker rs need to kno ture the fut A abilizers are fi utomatic Sta uring a recess sion and dem d abilizers are utomatic Sta A o Unem ployment com mpensation b o Corpo ax rate Profit Ta o Progre essive Income e Tax will not imme another size e economy elays if fiscal ow what econ iscal program mand restraint budget is not t balanced an d gate demand e are three m asy task there s legislative a ction but the nnually rathe r it
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