Chapter 12 Fiscal Policy Incentives and Secondary Effects expansionary fiscal policy during a recession government cut taxes and or increase spending running budget deficit Keynes believes this will stimulate AD and shift it right other economists disagree crowding out a reduction in private spending as a result of budget deficits financed by borrowing in the private loanable funds market o expansionary fiscal policy financed by deficit borrowing o this implies that expansionary fiscal policy won t restore the economy to full employment during a recession o when interest rates rise private investment is crowded out falling in output of capital goods reduces will lead to higher interest rates long run economic growth crowding in implies that restrictive fiscal policy won t dampen inflation during an expansion restrictive fiscal policy and budget surpluses lower interest rates new classical economics believe the economy tends toward full employment government borrowing shifts timing of taxes but not magnitude interest payments expansionary fiscal policy financed by budget deficit no change in interest rates o in the loanable funds market demand increases because of higher government borrowing and supply o Ricardian equivalence the theory that raising taxes and running a budget deficit are essentially equivalent increases because of more private saving and will have no impact on consumption or AD NOTE both the crowing out and new classical models indicate that secondary effects negate the stimulating impacts of expansionary fiscal policy Discretionary fiscal policy taxes than surpluses o no politician wants to be a Debby Downer spend money to directly benefit constituents reluctant to raise o countercyclical policy is not popular budget deficits are more attractive budget deficits are more common o economists agree timing of fiscal policy is difficult automatic stabilizers help mitigate fluctuations budget deficits have secondary impacts Supply Side Economics lower tax rates increase the incentive to work and invest investment causes capital formation increases long run aggregate supply higher tax rates reduce incentive to be productive decrease investment encourage purchases of fancy tax deductible stuff Will fiscal stimulus speed recovery Keynesians YES Tax cutting vs Spending increases Gov t spening increase is better than tax cuts tax cuts can be saved or spent abroad Non Keynesians NO more government debt means higher interest rates and less economic growth increased gov t spending will be politically motivated and more politically directed spending leads to less wealth creating production Tax cuts are better than gov t spending tax cuts can be implemented quickly and tax cuts are easier to reverse
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