ECONOMICS TOPIC 9 LESSON 2

ECONOMICS TOPIC 9 LESSON 2

Fiscal Policy Options

ESSENTIAL QUESTION

What is the proper role of government in the economy?

OBJECTIVES

•Compare and contrast classical economics and demand-side economics.

•Analyze the importance of John Maynard Keynes and his economic theories.

•Explain the basic principles of supply-side economics and the importance of Milton Friedman.

•Analyze the impact of fiscal policy decisions on the economy of the United States.

Classical Economics

In a free market, people act in their own self-interest, causing prices to rise or fall so that supply and demand will always return to equilibrium. This idea that free markets regulate themselves is central to the school of thought known as classical economics. Adam Smith, David Ricardo, and Thomas Malthus all contributed basic ideas to this school.

Classical Economics

The Great Depression, which began in 1929, challenged the classical theory. Prices fell over several years, so demand should have increased enough to stimulate production as consumers took advantage of low prices.

Instead, demand also fell as people lost their jobs and bank failures wiped out their savings.

Open Ended

During the Great Depression, government spending helped people like the family shown here. Generate Explanations Why do you think some people turn to the government for aid when times are difficult?

Multiple Choice

During the Great Depression, the U.S. economy seemed to defy the theories of classical economics. Which of the following illustrates this point?

• A. Supply should have increased as prices fell, but it did not.

• B. The supply of goods remained high, but prices continued to fall.

• C. Demand should have increased as prices fell, but it did not.

• D. The demand for goods remained strong, but prices continued to fall.

Keynesian Economics

British economist John Maynard Keynes developed a new theory of economics to explain the Great Depression. Keynes presented his ideas in 1936 in a book called The General Theory of Employment, Interest, and Money. He wanted to develop a comprehensive explanation of macroeconomic forces

Keynes Versus Classical Economics

British economist John Maynard Keynes developed a new theory of economics to explain the Great Depression. Keynes presented his ideas in 1936 in a book called The General Theory of Employment, Interest, and Money. He wanted to develop a comprehensive explanation of macroeconomic forces

Keynes Versus Classical Economics

Classical economists had always looked at how the equilibrium of supply and demand applied to individual products. In contrast, Keynes focused on the workings of the economy as a whole.

Keynes Versus Classical Economics

Keynes looked at the productive capacity of the entire economy. Productive capacity, often called full-employment output, is the maximum output that an economy can sustain over a period of time without increasing inflation.

Keynes Versus Classical Economics

The only way to end the Depression, Keynes thought, was to find a way to boost aggregate demand. Economists who agreed with the idea that demand drives the economy developed a school of thought known as demand-side economics.

Changing Government’s Role in the Economy

They asked themselves this question: Who could spend enough to spur demand and revitalize production? Keynes thought that the answer to that question was: the federal government. He reasoned that in the early 1930s, only the federal government still had the resources to spend enough to affect the whole economy.

Open Ended

Keynes sought to achieve the full productive capacity of the economy. Analyze Graphs According to Keynes, what could fill the gap between low output and full productive capacity?

Avoiding Recession

The federal government, Keynes argued, should keep track of the total level of spending by consumers, businesses, and government. If total spending begins to fall far below the level required to keep the economy running at full capacity, the government should watch out for the possibility of recession.

Keynes and Inflation

Keynes also argued that the government could use a contractionary fiscal policy to prevent inflation or reduce its severity. The government can reduce inflation either by increasing taxes or by reducing its own spending. 

The Multiplier Effect

Fiscal policy, although difficult to control, is a powerful tool. The key to its power is the multiplier effect. The multiplier effect in fiscal policy is the idea that each dollar spent or not taxed by government creates a change much greater than one dollar in the national income. In other words, the effects of changes in fiscal policy are multiplied.

Open Ended

The multiplier effect helps explain how government spending boosts the economy. Synthesize Explain how the multiplier effect supports Keynesian theory.

The Role of Automatic Stabilizers

A stable economy is one in which there are no rapid changes in economic indicators, which include stock prices, interest rates, and manufacturers’ new orders of capital goods. What’s more, set up properly, fiscal policy can come close to stabilizing the economy automatically.

The Role of Automatic Stabilizers

Taxes and transfer payments do not eliminate changes in the rate of growth of GDP, but they do make these changes smaller. Because they help make economic growth more stable, they are known as stabilizers.

Open Ended

The U.S. economy has experienced regular ups and downs since 1930. Analyze Graphs How do the years after World War II show the effect of automatic stabilizers?

Multiple Choice

Identify Main Ideas During the Great Depression, the federal government followed the ideas of John Maynard Keynes and

• A. increased spending.

• B. decreased spending.

• C. increased taxes.

• D. decreased taxes.

Supply-Side Economics

Another school of economic thought promotes a different direction for fiscal policy. Supply-side economics is based on the idea that the supply of goods drives the economy. Whereas Keynesian economics tries to encourage economic growth by increasing aggregate demand, supply-side economics relies on increasing aggregate supply.

Analyzing the Laffer Curve

Supply-side economists believe that taxes have a strong negative impact on economic output. They often use the Laffer curve, named after the economist Arthur Laffer, to illustrate the effects of taxes. The Laffer curve presents a supply-side view of the relationship between the tax rate and the total tax revenue that the government collects. 

Open Ended

The Laffer curve shows the theoretical effect increasingly higher tax rates have on tax revenues. Analyze Graphs According to the Laffer curve, what do both a very high and a very low tax rate produce?

The Relationship Between Taxes and Output

The heart of the supply-side argument is that a tax cut increases total employment so much that the government actually collects more in taxes at the new, lower tax rate. 

Open Ended

Federal revenue clearly rose throughout the period shown, even though the 1980s was a decade of tax cuts. Analyze Data Do the data here support the idea of supply-side economics? Explain.

Multiple Choice

Identify Central Ideas A basic principle of supply-side theory is that a tax cut

• A. decreases tax revenue.

• B. decreases employment.

• C. increases consumer demand.

• D. increases economic output.

The Recent History of U.S. Fiscal Policy

World War II- Keynes’s theory was fully tested in the United States during World War II. As the country geared up for war, government spending increased dramatically. This money was given to the private sector in exchange for goods. Just as Keynesian economics predicted, the additional demand for goods and services moved the country sharply out of the Great Depression and toward full productive capacity.

Postwar Keynesian Policy

Between 1945 and 1960, the U.S. economy was generally healthy and growing, despite a few minor recessions. The last recession continued into the term of President John F. Kennedy, with unemployment reaching a level of 6.7 percent. Kennedy’s chief financial policy adviser, chairperson of the CEA Walter Heller, thought that the economy was below its productive capacity.

Postwar Keynesian Policy

Keynesian economics was used often in the 1960s and 1970s. One Keynesian economist, John Kenneth Galbraith, greatly influenced national policies. Galbraith, a strong supporter of public spending, helped develop the far-reaching—and enormously costly—social welfare programs that lay at the heart of President Johnson’s vision of a Great Society.

Supply-Side Policy in the 1980s

During the late 1970s, with Keynesian fiscal policy in place, unemployment and inflation rates soared. When Ronald Reagan became President in 1981, he vowed to cut taxes and spending. An “anti-Keynesian,” Reagan did not believe that government should spend its way out of a recession

Supply-Side Policy in the 1980s

Reagan instituted policies based on supply-side economics, a theory promoted by economists such as George Gilder. Among Reagan’s advisers was Milton Friedman, a former professor of economics. Friedman strongly supported individual freedom and pushed for more laissez-faire policies—hallmarks of classical and supply-side economics.

A Return to Keynes

In late 2008, the United States was hit with what many economists believed was the worst financial crisis since the Great Depression. A number of major financial institutions failed. Credit became harder to get, consumer spending dropped, and unemployment rose. The crisis occurred in the midst of what news commentators named the Great Recession, an economic downturn that had begun in December 2007.

A Return to Keynes

In November 2008, voters elected a new President, Barack Obama. He promised to take firm action to stimulate the economy. Obama signed a stimulus bill in February 2009 that aimed to boost demand and create jobs. The $840 billion package included contracts, grants, and loans for education, transportation, and infrastructure projects. It unfortunately failed to produce results.

A Return to Supply side

In November 2016, voters elected a new President, Donald J. Trump. He promised to "Make America Great Again". He returned to a supply side policy that brought the economy out of the recession and increased the economy to strongest ever recorded.

Multiple Choice

Recall How did President Reagan bring about a shift in U.S. economic policy?

• A. He revived President Roosevelt’s Keynesian approach.

• B. He instituted policies based on supply-side economics.

• C. He increased taxes to reduce the budget deficit.

• D. He cut the defense budget to avoid deficit spending.

Open Ended

What is the proper role of government in the economy?