Fiscal Policy: The Keynesian View and Historical Perspective Macro Chapter 11 Fiscal Policy: The Keynesian View and Historical Perspective

6 Learning Goals List the key arguments in Keynesian Economics Describe the multiplier process then identify potential problems with the process Define a budget surplus and deficit (on your own) Differentiate between restrictive and expansionary fiscal policy Explain how fiscal policy is implemented Discover timing issues related to fiscal policy

The Great Depression and the Macroadjustment Process

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John M. Keynes Incredibly influential economist Major points of thinking: 1. Resource prices and interest rates are not very flexible so they won’t direct an economy to equilibrium 2. Changes in output will direct an economy to equilibrium

John M. Keynes 1935, about his forthcoming book The General Theory of Employment, Interest and Money “I believe myself to be writing a book on economic theory which will largely revolutionize not, I suppose, at once but in the course of the next ten years the way the world thinks about economic problems.”

Friedrich Hayek 1944, The Road to Serfdom According to the views now dominant, the question is no longer how we can make the best use of the spontaneous forces found in a free society. We have in effect undertaken to dispense with the forces which produced unforeseen results and to replace the impersonal and anonymous mechanism of the market by collective and "conscious" direction of all social forces to deliberately chosen goals.

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Q11.1 Which economist taught at The London School of Economics? John M. Keynes Friedrich Hayek Joe Calhoun 30

Q11.2 Which economist said “in the long run, we’re all dead”? John M. Keynes Friedrich Hayek Joe Calhoun 30

For more about Keynes & Hayek: See Supplemental Video Free to Choose (FTC) Keynesian economics If you really want details, see supplemental videos Commanding Heights 1, Chapters 1 through 8 For fun, check on the two videos “Fear the Boom and Bust” and “Fight of the Century” (lyrics also provided)

For Optional Credit: Watch Supplemental Video “Free to Choose (FTC) Keynesian economics” Watch either video “Fear the Boom and Bust” or “Fight of the Century” (lyrics also provided) For $25, write a one-paragraph summary of Keynes’ economic philosophy and a one-paragraph summary of Hayek’s economic philosophy. Submit by 10/31.

The Solution? Y = C + I + G + X If C, I, and X are stagnant or declining, increase G After the multiplier kicks in, C, I, and X will increase AD shifts right until full employment is reached

This is not ancient economic theory President Obama in February, 2009:

What is the multiplier and how does it work? Demonstration: Class Activity: Identify at least one problem associated with the multiplier.

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Q11.3 A hail storm that breaks lots of windows in buildings is good for the economy because the spending on repairs will expand net employment. good for the economy because spending on the repairs will drive up the general level of prices. bad for the economy because the damage from the storm will be subtracted from this year’s GDP. bad for the economy because wealth was destroyed and more spending on repairs will result in less spending on other goods and services. 60

What are some problems associated with the multiplier? Video:

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Q11.4 Within the Keynesian model, the multiplier effect tends to smooth out the up and down swings of the business cycle. promote price stability. magnify small changes in spending into much larger changes in output and employment. reduce the impact of an increase in investment on output and employment. 59

Key Points: The multiplier “works” with an increase in C, I, G, or X The multiplier is more potent when 1. Unemployment is unusually high 2. There is an increase in C, I, or X The multiplier is less potent when 1. Unemployment is closer to natural rate 2. There is an increase in G (because of secondary effects)

Note: You do not need to remember the formula for the multiplier No quiz or exam questions will ask you to calculate the multiplier or know the relationship between MPC and M

The Keynesian View of Fiscal Policy

6 Learning Goals Define a budget surplus and deficit (on your own)

What is fiscal policy? Fiscal policy is simply the tools used by Congress and the President to alter economic activity Primary tools are government spending and taxes

Fiscal Policy and the Good News of Keynesian Economics

How does fiscal policy work? Increase gov’t spending and/or decrease taxes Expansionary- try to increase AD Decrease gov’t spending and/or increase taxes Restrictive- try to decrease AD Class Activity: What will happen to the deficit if the government engages in expansionary policy? What will happen to the deficit with restrictive policy?

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an increase in tax rates a balanced budget a budget deficit Q11.5 According to Keynesian theory, which of the following would most likely stimulate an expansion in real output if the economy were in a recession? an increase in tax rates a balanced budget a budget deficit a budget surplus 60

Discuss with a neighbor before answering the next question

Q11.6 The government is pursuing an expansionary fiscal policy if it decreases government spending and/or increases taxes. increases government spending and/or increases taxes. decreases government spending and/or reduces taxes. increases government spending and/or reduces taxes. 60

What are some common problems of fiscal policy? Even if you believe fiscal policy works, there are still some potential problems

Let’s say we want to “fix” the economy Let’s say we want to “fix” the economy. What problems might we encounter? First, we have a recognition lag Second, we have an implementation lag Third, we have an effectiveness lag

Will Rogers: “We could certainly slow the aging process down if it had to work its way through Congress”

Note: You do not need to know the details of automatic stabilizers

6 Learning Goals List the key arguments in Keynesian Economics Describe the multiplier process then identify potential problems with the process Define a budget surplus and deficit (on your own) Differentiate between restrictive and expansionary fiscal policy Explain how fiscal policy is implemented Discover timing issues related to fiscal policy