I have a quick review question for you: which economists believe that the economy is not
self-regulating, Classical or Keynesian?
Keynesian economists believe the economy will not self-adjust.
Remember that this model arose from the evidence of the Great Depression, when the global economy
was in decline for an extended period.
Because Keynesians do not believe that economic problems are going to take care of themselves,
they conclude that the government should play a very active role in the economy.
What kind of role?
There are actually different tools that can be used to manage the economy, but let's start
with fiscal policy.
First of all, what is fiscal policy?
By definition, fiscal policy is changes in government expenditures and taxation to achieve
particular macroeconomic goals; that is, to achieve stable prices, low unemployment, and
high & sustained growth.
In a country like the United States, who is it the controls government spending and taxation?
It's going to be our legislative and executive branches.
Fiscal policy can be used to stimulate a sluggish economy, or to slow down an economy that's
moving too fast.
Expansionary fiscal policy is typically represented by stimulus to the aggregate demand (although
it certainly is possible to stimulate aggregate supply).
Aggregate demand can be increased by either increasing government spending, or decreasing
taxes.
Since aggregate demand is composed of consumption, investment, government spending, and net exports,
an increase in government spending has a direct, immediate effect on aggregate demand; a tax
cut, which will encourage spending on the part of households and businesses, has an
indirect effect on aggregate demand as consumption and investment rise.
Contractionary fiscal policy is typically represented by some type of drag on the aggregate
demand -- either decreasing government spending, or increasing taxes.
Again, a change in government spending will have a direct effect on aggregate demand,
whereas a change in taxes will indirectly affect aggregate demand, by way of households
and businesses.
TIME TO THINK: If you were a politician, which type of policy, expansionary or contractionary,
would you like better?
Well, if I were a politician, and my primary objective was to get re-elected to office,
I’d want the policy that's more popular with the voters.
After all, what will the voters like better: tax cuts, and more spending on their favorite
programs (that is, expansionary policy), or higher taxes and cuts to their favorite programs
(contractionary policy)?
Well, as a politician, I would prefer expansionary policy, because voters prefer expansionary
policy.
The problem, though, is the effect that such a policy has on the nation's deficit and,
in turn, its debt.
The deficit is how much overspending there is in a single year; the debt is the accumulation
of all the deficits we've ever run.
Expansionary fiscal policy -- lower taxes and/or higher government spending – adds
to our deficit and in turn, our debt.
When we get to taxes and budget in Episode 28, we’ll look at interest payments on the
debt.
Yes, for the government to engage in deficit spending, it must borrow -- just like you
do when you spend more money than you have -- and then it has to pay back the loan with
interest.
And we’ll look at the subsequent drag on the economy.
So -- expansionary fiscal policy (lower taxes and/or higher spending) will increase aggregate
demand; contractionary policy (higher taxes and/or lower government spending) will decrease
aggregate demand.
If fiscal policy is meant to address the three macroeconomic goals, when is each type of
policy appropriate?
Well, if it is a recessionary gap, where the equilibrium GDP is lower than our potential
(which also means that unemployment is higher than the natural rate), expansionary policy
would be the appropriate response.
As aggregate demand increases, the economy moves to full employment and potential GDP.
If there's an inflationary gap, where equilibrium GDP is higher than the full employment level,
and unemployment is so low that it's likely to cause inflation, contractionary policy
would be appropriate response.
As aggregate demand falls, the economy slows, bringing us back to potential output -- the
full employment level.
A Classical economist would probably ask, “Why not just wait for aggregate supply
to move, and allow it to correct the economy?”
If you do not believe that the economy will self-adjust, or even if you think that it
may self-adjust, but only over very long time, then you probably prefer a more active, hands-on
policy to help things along.
NEXT TIME: Should we use fiscal policy?
TRANSCRIPT00(MACRO) EPISODE 26: FISCAL POLICY