How the Government Fixes Economic Instability

As the American economy slid into recession in 1929, economists relied on the classical theory of economics, which promised that the economy would self-correct if government did not interfere.

But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. One of the most important functions of our government today is to try to correct inflation and recession in our economy.

Economic Schools of Thought Mercantilists – Economic philosophy adopted by merchants and statesmen of Western European countries during the 16 th - late 17 th centuries – believed that a nation's wealth came primarily from the accumulation of gold and silver – Idea that government control of foreign trade is vitally important in ensuring the military security of the country – Cause of frequent European wars and motivated colonial expansion – Mercantilist policies include: High tariffs, especially on manufactured goods Building a network of overseas colonies Forbidding colonies to trade with other nations Banning the export of gold and silver Forbidding trade to be carried in foreign ships Monopolizing markets with staple ports (a port where ships could only unload and sell their goods at)

Economic Schools of Thought Physiocrats – Group of 18 th century French philosophers – Idea of economy as a circular flow of income and output – Opposed mercantilist policy – Believed agriculture was the sole source of wealth in an economy – Advocated for laissez-faire (minimal government interference in the economy)

Economic Schools of Thought Classical School – Began with Adam Smith’s work The Wealth of Nations in 1776 – Smith identified land, labor, and capital as the three factors of production and the major contributors to a nation's wealth – In Smith's view, the ideal economy is a self-regulating market system that automatically satisfies the economic needs of the populace. – The “invisible hand” = leads all individuals in pursuit of their own self-interests to produce the greatest benefit for society as a whole – Incorporated some of the Physiocrats’ ideas (laissez-faire) but rejected that only agriculture was productive

Economic Schools of Thought Marginalist School – Classical economists believed that prices are determined by the costs of production – Marginalist economists instead believed that prices also depend on the level of demand, which also depends on consumer satisfaction – The factors of production (land, labor, and capital) receive returns equal to their contributions to production Justifies the existing distribution of income = that people earned exactly what they or their property contributed to production

Economic Schools of Thought Marxist School – Developed by Karl Marx during the mid-19 th century who believed that capitalism would destroy itself and be succeeded by a world without private property – Saw capitalism as an evolutionary phase in economics – Believed that the market system allows capitalists to exploit workers by denying them a fair share of what they produce

Economic Schools of Thought Institutionalist School – Reject the Classical idea that people are motivated first by economic self-interest – Oppose laissez-faire, instead call for more government controls and social reform to bring about a more equal distribution of income

Economic Schools of Thought Keynesian School – Created by the British economist John Maynard Keynes – Overturned older ideas of Neoclassical economics The Classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing people's incomes, would prevent a revival of spending. He insisted that direct government intervention was necessary to increase total spending. – Advocates for the use of fiscal and monetary measures to fix economic recessions and depressions Gov’t would spend & decrease taxes when private spending was down & threatening a recession; it would reduce spending & increase taxes when private spending too high & threatened inflation – Also advocates for a mixed economy (predominately private sector but to have the government intervene during recessions) – Served as the standard economic model during the later part of the Great Depression, WWII, the post war economic expansion (1945-early 1970s) – Lost some influence during the oil embargo and stagflation of the 1970s but was brought back during the global financial crisis in 2008

Economic Theories for fixing the Economy Supply-side economics – Growth happens when tax rates are lowered to allow people to produce more goods and services and have more flexibility by reducing regulation – Consumers benefit from a greater supply of goods and services, which are now at lower prices, and consumers have more $$ to spend with tax cuts – Typical policy recommendations are lower tax rates and less regulation Trickle-down economics – Similar to supply-side economics – The idea that tax breaks or other economic benefits provided by the government to businesses and the wealthy will “trickle down” to benefit poorer members of society by improving the economy as a whole – Used during the Great Depression in that the money was all given to the top in hopes it would trickle down to the needy Monetarism – Emphasizes the role of the government in controlling the amount of money in circulation – Idea that money is always inflationary and that monetary authorities should focus only on maintaining price stability – Raise interest rates to control the money in circulation

Monetary vs. Fiscal Policy Monetary policy = how the monetary authority of a country (U.S. Federal Reserve) controls the supply of money – Targets a rate of interest to promote economic growth and stability Fiscal policy = the use of government revenue (taxation) and expenditure (government spending) as well as borrowing $$ to influence the economy