Government Intervention in the Free Market? Fiscal Policy Government Intervention in the Free Market?

Classical Model Failure: The Great Depression Real GDP ↓ 27% Unemployment 3% → 25% Price Level fell Price Level LRAS1 AD2 AD1 However, Wages did not adjust Real GDP

John Keynes 1883-1946 Argued Government intervention was necessary to moderate the “ups & downs” of business cycle Recessions could be long or permanent Dominated economics during Great Depression

2 Types of Fiscal Policy => => Expansionary Policy Used in recessionary gap Contractionary Policy Used in inflationary gap AD => Increase Gov’t Spending Decrease Taxes Decrease Gov’t Spending Increase Taxes AD =>

Fiscal Policy Introduction Worksheet LRAS1 Price Level Real GDP SRAS1 AD1

Expansionary Fiscal Policy Contractionary Fiscal Policy Recessionary Gap Inflationary Gap Economy below full output Economy above full output Expansionary Fiscal Policy Gov’t would lower income taxes => (C↑) Increase Gov’t Spending (G↑) End result: AD shifts right, debt rises Contractionary Fiscal Policy Gov’t would raise income taxes => (C↓) Decrease Gov’t Spending (G↓ ) End result: AD shifts left, debt falls LRAS1 Price Level Real GDP SRAS1 LRAS1 Price Level Real GDP SRAS1 AD1 AD1