CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 1 Fiscal Policy, Deficits, and Debt The Evolution of Fiscal Policy 15.2Fiscal Policy Reconsidered 15.3Federal Deficits and Federal Debt

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 2 What is your normal capacity for academic work, and when do you usually exceed that effort? If the economy is already operating at full employment, how can it produce more? Can fiscal policy reduce swings in the business cycle? Why has the federal budget been in deficit most years? How is a strong economy like a crowded restaurant? What did President George W. Bush mean when he proposed a tax cut to “get the economy moving again”? CONSIDER

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1The Evolution of Fiscal Policy  Identify the economy’s potential output level.  Distinguish between fiscal policy before and after the Great Depression. Objectives

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1The Evolution of Fiscal Policy  potential output  natural rate of unemployment  classical economists  annually balanced budget  multiplier effect Key Terms

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 5 Fiscal Policy and Potential Output Fiscal policy aims to use government taxing and spending to move the economy toward full employment with price stability. The focus is mainly on shifts of the aggregate demand curve.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 6 Potential Output Potential output is the economy’s maximum sustainable output in the long run. Potential output also is referred to as the full-employment output. The natural rate of unemployment is the unemployment rate when the economy is producing its potential level of output.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 7 Fiscal Policy and Potential Output The pink-shaded area indicates real GDP below the economy’s potential. The blue-shaded area indicates real GDP exceeding the economy’s potential. Figure 15.1

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 8 Output Below Potential The economy is not producing as much as it can. Unemployment exceeds its natural rate. The amount by which short-run output falls short of the economy’s potential output is called a contractionary gap.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 9 Output Exceeding Potential Unemployment is below its natural rate. The amount by which actual output in the short run exceeds the economy’s potential output is called the expansionary gap.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 10 How Can Output Exceed the Economy’s Potential? Potential output means not zero unemployment, but the natural rate of unemployment. Even in an economy producing its potential output, there is still some unemployed labor and some unused production capacity.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 11 Discretionary Fiscal Policy to Close a Contractionary Gap The aggregate demand curve AD and the aggregate supply curve AS intersect at point e. Output of $11.5 trillion falls short of the economy’s potential of $12.0 trillion. The result is a contractionary gap of $0.5 trillion. Figure 15.2

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 12 Discretionary Fiscal Policy to Close a Contractionary Gap Figure 15.2 (continued) This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government spending, a decrease in taxes, or some combination of the two could shift aggregate demand to AD*, moving the economy to its potential level of output at e*.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 13 The Rise of Fiscal Policy Before the Great Depression, most policy makers believed that an economy producing less than its potential in the short run would move to its potential in the long run without help from the federal government. They thought the government should just balance its budget and forget about trying to stabilize the economy in the short run.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 14 The Rise of Fiscal Policy Before the Great Depression, the federal government played a relatively minor role in the economy. Federal spending as a percent of GDP 3 percent at the onset of the Great Depression 20 percent today (continued)

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 15 View of Classical Economists Classical economists—A group of laissez-faire economists, who believed that economic downturns corrected themselves in the long run through natural market forces Annually balanced budget—Matching annual spending with annual revenue, except during war years; approach to the federal budget prior to the Great Depression

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 16 The Great Depression and Keynes Keynesian theory and policy were developed to address the problem of unemployment during the Great Depression.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 17 The Multiplier Effect Keynes also argued that any change in taxing or government spending had a magnified effect on aggregate demand. Each round of income and spending increases aggregate spending a little more. The multiplier effect of fiscal policy says that any change in fiscal policy affects aggregate demand by more than the original change in spending or taxing.

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 18 The Rise of Fiscal Policy Three developments in the years following the Great Depression supported the use of fiscal policy in the United States. The influence of Keynes’s General Theory The powerful impact World War II had on output and employment The passage of the Employment Act of 1946