Fiscal Policy: The Keynesian View and Historical Perspective. 3. 11. 3. 11. The Great Depression and Macroeconomics. The Great Depression exerted a huge impact on macroeconomics. The national income accounts that we use to measure GDP were developed during this era. - PowerPoint PPT Presentation
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To Accompany “Economics: Private and Public Choice 13th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: Joseph Connors, James Gwartney, & Charles Skipton
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Game Plan for Analysis of Fiscal Policy• This chapter will present the Keynesian view
of fiscal policy and consider how it has evolved through time.
• The next chapter will focus on alternative theories and consider incentive effects that are largely ignored within the Keynesian framework.
• Taken together, these two chapters provide a balanced presentation of current views on the potential and limitations of fiscal policy as a stabilization tool.
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The Multiplier Principle• The concept that an independent change in
expenditures (such as investment) leads to an even larger change in aggregate output.
• The multiplier concept builds on the point that one individual’s spending becomes the income of another.
• Income recipients will spend a portion of their additional earnings on consumption. In turn, their consumption expenditures will generate additional income for others who also spend a portion of it.
• Thus, growth in spending can expand output by a multiple of the original increase.
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effectively, $4 million is spent in the economy.
• Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until …
Expenditure stage
Additional income(dollars)
Marginal propensity to consume
Additional consumption(dollars)
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
1,000,000 750,000
562,500
421,875
316,406
949,219
750,000 562,500
421,875
316,406
237,305
711,914
Round 1
Round 2
Round 3
Round 4
Round 5
Total 4,000,000 3,000,000
All others
3/4 3/4
3/4
3/4
3/4
3/4
3/4
The Multiplier Principle (Exhibit 1)
• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).
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The Multiplier Principle• The term multiplier is also used to indicate
the number by which the initial change in spending is multiplied to obtain the total increase in output.• In the previous example, a $1 million initial
increase in spending expanded output by a total of $4 million. Thus the multiplier was 4.
• The size of the multiplier increases with the marginal propensity to consume (MPC).
• Specifically the relationship between the MPC and the multiplier follows this equation:
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The Multiplier and Economic Instability• The multiplier concept also works in reverse –
reductions in spending will also be magnified and generate even larger reductions in income.• Even a minor disturbance may be amplified
into a major disruption because of the multiplier.
• Keynesians argue that the multiplier concept indicates that market economies have a tendency to fluctuate back and forth between excessive demand that generates an economic boom and deficient demand that leads to recession.
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Keynes and Economic Instability:A Summary• According to the Keynesian view, fluctuations
in total spending (AD) are the major source of economic instability.
• Keynesians believe that market economies have a tendency to fluctuate between economic booms driven by excessive demand and recessions resulting from insufficient demand.
• The multiplier concept magnifies these fluctuations.
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Budget Deficits and Surpluses• Changes in the size of the federal deficit or
surplus are often used to gauge whether fiscal policy is stimulating or restraining demand.
• Changes in the size of the budget deficit or surplus may arise from either: • a change in cyclical economic conditions • a change in discretionary fiscal policy
• The federal budget is the primary tool of fiscal policy.
• Discretionary changes in fiscal policy: deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.
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Fiscal Policy and the Good News of Keynesian Economics• Keynesian theory highlights the potential
of fiscal policy as a tool capable of reducing fluctuations in AD.
• Prior to the Great Depression, it was widely believed that the government should balance its budget. Keynesians challenged this view.• Rather than balancing the budget annually,
Keynesians argue that counter-cyclical policy should be used to offset fluctuations in AD.
• This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.
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Questions for Thought:1. What is the multiplier principle? Does
the multiplier principle make it more or less difficult to stabilize the economy? Explain.
2. Why did John Maynard Keynes think the high level of unemployment persisted during the Great Depression? What did he think needed to be done to avoid the destructive impact of circumstances like those of the 1930s?
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Problems with Proper Timing• There are three major reasons why it is
difficult to time fiscal policy changes in a manner that promotes stability:• It takes time to institute a legislative change.• There is a time lag between when a change is
instituted & when it exerts significant impact.• These time lags imply that sound policy
requires knowledge of economic conditions 9 to 18 months in the future. But, our ability to forecast future conditions is limited.
• Discretionary fiscal policy is like a two-edged sword; it can both harm and help. • If timed correctly,
it may reduce economic instability.• If timed incorrectly, however,
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Automatic Stabilizers• Automatic Stabilizers:
Without any new legislative action, these tools will increase the budget deficit (reduce the surplus) during a recession and increase the surplus (reduce the deficit) during an economic boom.
• The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action.
• Examples of automatic stabilizers:• unemployment compensation• corporate profit tax • progressive income tax
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Questions for Thought:1. Why is the proper timing of changes in fiscal
policy so important? Why is it difficult to achieve?
2. Automatic stabilizers are government programs that tend to:a. bring expenditures and revenues automatically into balance without legislative action.b. shift the budget toward a deficit when the economy slows but shift it towards a surplus during an expansion.c. increase tax collections automatically during a recession.
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Aggregate Consumption Function
4 7 10
Planned consumption(trillions of $)
Real disposable income
(trillions of dollars)
7
10
13
4
45º
45º line
C
Dissaving
Saving
• The Keynesian model assumes that there is a positive relationship between consumption and income.
• However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line).
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Total Output(real GDP)
Planned aggregateexpenditures
Planned consumption
Plannednet exports
Tendencyof output
Planned investment plusgovernment expenditures
Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports
$ 13.4 13.7
14.0
14.3
14.6
$ 13.70 13.85
14.00
14.15
14.30
$9.1 9.3
9.5
9.7
9.9
$0.20 0.15
0.10
0.05
0.00
$4.4 4.4
4.4
4.4
4.4
Expand Expand
Equilibrium
Contract
Contract >
An Example of Keynesian Equilibrium
> =<<
• In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories decline. Firms expand their output to rebuild their inventories to regular levels.
• When output is more than planned aggregate expenditures, output exceeds purchases, and inventories rise. Firms reduce output in order to reduce excessive inventories.
• When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.
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Keynesian Equilibrium
Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• At output levels below $14.0 trillion (for example 13.7) AE is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output.
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Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• At output levels above $14.0 trillion (for example 14.3) AE is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output.
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Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at $14.0 trillion.
14.3
AE = C + I + G + NX
14.15
13.7
13.8514.00
14.0
• Full-employment for this example exists at $14.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment.
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Output(Real GDP -- trillions of $)
Planned aggregate expenditures(trillions of $)
45º
• Once full employment is reached, further increases in AE, such as to AE3, lead only to higher prices – nominal output expands along the black segment of AE (those points beyond the full employment output level at $14.3 trillion) but real output does not.
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Aggregate Expenditure and AD-AS Models• The AE model implies that increases in
demand will expand output until full employment is reached.• Within the AD-AS model, this implies that the
SRAS curve is horizontal until full employment is achieved.
• Once full employment is reached, the AE model implies that additional demand will lead only to a higher price level.• Within the AD-AS model, this implies that the
SRAS curve is vertical at the full employment level of output.
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Shifts In Demand, Prices, and Output• An important implication of Keynesian
analysis within the AD-AS framework:• When substantial idle resources are present,
increases in AD will lead primarily to an expansion in output and the impact on the general level of prices will be small.
• When an economy is at or near full employment, increases in AD will lead primarily to a higher price level rather than a substantial increase in output.
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Questions for Thought:1. According to the Keynesian view, which of
the following is true? a. Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. b. If planned aggregate expenditures are less than full employment output, output will fall short of its potential.c. Equilibrium can only occur at the full employment rate of output.
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Questions for Thought:2. Within the framework of the Keynesian AE
model, if the planned expenditures on goods and services were less than current output, a. business firms would reduce their output and lay off workers in the near future.b. the wage rates of workers would decline and thereby help to direct the economy to full employment.