Calhoun Midterm 3 Study Guide Macroeconomics Chapter 11 Fiscal Policy The Keynesian View and Historical Perspective The Great Depression and Macroeconomics The Great Depression exerted a huge impact on macroeconomics The national income accounts that we use to measure GDP were developed during this era Several of the basic concepts of macroeconomics and much of the terminology were initially introduced during the 1930s Keynesian economics was also an outgrowth of the Great Depression Keynesian Economics A Historical Overview John Maynard Keynes was probably the most influential economist of the 20th Century Keynes developed a theory that provided both an explanation for the prolonged unemployment of the 1930s and a recipe for how to generate a recovery Keynesian analysis indicated that fiscal policy could be used to maintain a high level of output and employment The Keynesian view dominated macroeconomics for 3 decades following WWII Keynesian economics began to wane during the 1970s because it was unable to explain the simultaneous occurrence of high unemployment and inflation But the severe recession of 2008 2009 generated renewed interest in Keynesian analysis The Great Depression and the Macroadjustment Process Prior to the Great Depression most economists thought market adjustments would direct an economy back to full employment rather quickly The length and severity of the Great Depression changed these views The Great Depression and the Macroadjustment Process The depth and length of the economic decline during the 1930s is difficult to comprehend In 1933 nearly 25 of the U S labor force was unemployed Between 1929 and 1933 real GDP fell by more than 30 The depressed conditions were prolonged In 1939 a decade after the plunge began the rate of unemployment was still 17 and per capita income was virtually the same as a decade earlier The Great Depression and Keynesian Economics Keynes provided an explanation for the prolonged depressed conditions of the 1930s He argued that spending motivated firms to produce output If spending fell because of pessimism and other factors firms would reduce production When an economy is in recession Keynesians do not believe that reductions in either resource prices or interest rates will promote recovery As a result market economies are likely to experience recessions that are both severe and lengthy The Keynesian Concept of Equilibrium In the Keynesian model firms will produce the amount of goods and services they believe people plan to buy Equilibrium occurs when total spending equals current output When this is the case producers have no reason to expand or contract output If total spending demand is deficient depressed conditions and high levels of unemployment will persist This is precisely what Keynes believed happened during the 1930s If total spending is less than full employment output inventories will rise and firms will reduce output and employment The lower level of output and employment will persist as long as total spending is less than output Total spending AD is key to the Keynesian macroeconomic model Keynes believed that the cause of the Great Depression was weak AD deficient total spending on goods and services The Multiplier and Economic Instability The multiplier concept also works in reverse reductions in spending will also be magnified and generate even larger reductions in income Even a minor disturbance may be amplified into a major disruption because of the multiplier Keynesians argue that the multiplier concept indicates that market economies have a tendency to fluctuate back and forth between excessive demand that generates an economic boom and deficient demand that leads to recession Keynes and Economic Instability A Summary According to the Keynesian view fluctuations in total spending AD are the major source of economic instability Keynesians believe that market economies have a tendency to fluctuate between economic booms driven by excessive demand and recessions resulting from insufficient demand The multiplier concept magnifies these fluctuations The Keynesian View of Fiscal Policy Budget Deficits and Surpluses Budget deficit present when total government spending exceeds total revenue from all sources When the money supply is constant deficits must be covered with borrowing The U S Treasury borrows by issuing bonds Budget surplus present when total government spending is greater than total revenue Surpluses reduce the magnitude of the government s outstanding debt Keynesian View of Fiscal Policy A Summary The federal budget is the primary tool of fiscal policy Keynesians stress the importance of counter cyclical policy The budget should shift toward deficit when the economy is threatened by recession The budget should shift toward surplus when inflation is a threat Fiscal Policy Changes and Problems of Timing The Keynesian Aggregate Expenditure Model Aggregate Expenditure and AD AS Models The AE model implies that increases in demand will expand output until full employment is reached Within the AD AS model this implies that the SRAS curve is horizontal until full employment is achieved Once full employment is reached the AE model implies that additional demand will lead only to a higher price level Within the AD AS model this implies that the SRAS curve is vertical at the full employment level of output Shifts In Demand Prices and Output An important implication of Keynesian analysis within the AD AS framework When substantial idle resources are present increases in AD will lead primarily to an expansion in output and the impact on the general level of prices will be small When an economy is at or near full employment increases in AD will lead primarily to a higher price level rather than a substantial increase in output Chapter 12 Fiscal Policy Incentives and Secondary Effects Alternative Views of Fiscal Policy Keynesians stress the potency of fiscal policy and its use to maintain AD at a level consistent with full employment Others argue there are secondary effects of fiscal policy which undermine its effectiveness Critics also argue that Keynesian analysis ignores important incentive effects of fiscal changes including both changes in the composition of government spending and the supply side effects of marginal tax rates Note The main difference between Keynes and modern economics is the focus on incentives Keynes studied the relation between macroeconomic aggregates without any consideration for
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