Chapter 15 Fiscal Policy

Demand –Side Policies Keynesian economics is an approach to fiscal policy designed to lower unemployment by stimulating aggregate demand. In Keynes’s framework—the aggregate output-expenditure model of GDP = C + I + G + (X – M)—the variables refer to the economic sectors. During the Great Depression, Keynes concluded that unstable spending by the investment (business) sector caused GDP to decline. Keynes identified a multiplier effect in which unstable spending by the investment sector has a magnified effect on the total economy. Keynes also identified an accelerator: the change in investment spending caused by a change in overall spending. Together, the multiplier and accelerator push the GDP into a deep and fast downward spiral.

Impact of demand side policies Keynes concluded that the problem during the Great Depression was lack of spending, so he encouraged the government—the only sector large enough—to spend in order to offset the changes in investment spending. Keynes justified temporary federal deficits as necessary to stop further declines in economic activity. In the 1960s, economists suggested “priming the pump,” thinking that a small amount of government spending would initiate a bigger round of overall spending in the economy. A key component of demand-side policies is automatic stabilizers that automatically trigger benefits if changes in the economy threaten income; these include unemployment insurance and some entitlement programs.

Limitations of demand side policies Recognition, legislative, and implementation lags prevent the government from responding to economic issues as quickly as Keynes envisioned. People may become increasingly dependent on the federal government, rather than use their own skills and initiative. A tipping point will eventually occur when people decide that the burden of taxes needed to finance government expenditures outweigh the benefits. Even after the economy recovers, politicians have never been able to fully cut back on government spending during a decline in investment spending.

Goals of Supply Side Policies Supply-side policies target producers to stimulate their output, thereby providing jobs. Demand-side policies began to falter in the 1970s, and in 1981 supply- side policies became the hallmark of President Reagan’s administration. A key goal for supply-side policies is to reduce the economic role of the federal government. Supply-side policies attempt to reduce the federal tax burden on individuals and businesses, which theoretically allows them to spend more money and produce more goods. The Laffer curve predicted increased tax revenues in spite of lower taxes, but this benefit never materialized. Supply-siders support deregulation, the relaxing or removal of government regulations restricting the activities of certain industries.

The Laffer Curve and Reaganomics In the 1980s, as part of President Reagan’s move to prove that less government is better, Arthur Laffer’s ideas were put in play. Taxes were cut with the expectation that tax revenues would increase. The result was the opposite – tax revenues fell. Today most economists believe that we are in the range of Laffer curve where tax rates and tax revenues move in the same, not opposite, direction.

Impact and limitations of supply side policies The net effect of President Reagan’s budget priorities was a 2.5 percent increase in government spending. The economy during Reagan’s administration partly supported supply- sider claims that reduced government regulation would provide strong economic growth; but because military spending also created an economic stimulus, the growth was not entirely due to supply-side policy. Contrary to supply-side expectations, tax rate cuts by both Reagan and Bush resulted in a fall in revenues. Many economists believe that supply-side policies have made the economy less stable, but supply-side policies are designed to promote economic growth, not provide stability. Supply-side and demand-side policies both have the same goal of increasing production while decreasing unemployment, without increasing inflation.

Aggregate Supply Aggregate supply is the total value of goods and services that all firms would produce in a specific period of time at various price levels. Over a one-year period, if all production takes place within the country’s borders, aggregate supply equals the GDP. An aggregate supply curve shows the amount of real GDP that would be produced at various price levels. Decreases in the cost of production tend to increase aggregate supply, and increases in the cost of production tend to decrease aggregate supply.

Aggregate Demand Aggregate demand is the total demand for every good and service in the economy at different price levels. The aggregate demand curve represents the sum of demand from all economic sectors at various price levels. When aggregate demand increases, spending is increased and the curve shifts to the right, but when people save more and spend less, aggregate spending is reduced and the curve shifts to the left.

Macroeconomic Equilibrium Aggregate supply and demand curves can be used together to analyze how proposed policies might affect growth and price stability. Macroeconomic equilibrium is the point of intersection between the aggregate supply curve (AS) and the aggregate demand curve (AD). Macroeconomic equilibrium can change as a result of changes in either AS or AD. Demand-side policies affect the aggregate demand. Supply-side policies affect the aggregate supply. The economy needs a combination of demand-side and supply- side policies.