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

2. 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

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

4. 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
=>

5. Fiscal Policy Introduction Worksheet
LRAS1
Price
Level
Real
GDP
SRAS1
AD1

6. 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