Crowding Out

The Expenditure Approach

In Week #5, we discussed how severe downturns in the economy can eventually be destructive and end up as an economic depression, such as that of the 1930's called the Great Depression.

· Severe drops in output, relative high real unemployment, economic contraction, and apathy occur during severe recessions and periods of economic depression.

One famous economist who was called upon to address the economic malaise of the 1930's period was John Maynard Keynes. Published in 1933, The Means to Prosperity was Keynes' economic theories and ideas about government responsibility and authority on how to revive a sluggish economy.

The Expenditure Approach derives GDP by taking consumption (C) and adding business investment (I) and adding government expenditures of goods and services (G) and adding net exports (exports - imports). To Keynes, C + I is equal to aggregate demand, and equilibrium is the result of aggregate spending (C + I + G + NX) being equal to total economic output. If total spending is less than it would be if there were full employment (no cyclical unemployment), then there will be economic recessionary pressures.

Once an economy moves out of long-run equilibrium in which long-run aggregate supply, short-run aggregate supply, and aggregate demand are in equilibrium, what happens and should happen? Keynes believed that prices and wages were sticky in the short run, but as long as aggregate spending was below full employment, there will be economic instability and supply won't change.

· Thus, the key would be to concentrate on shifting aggregate demand rightward back into long-run equilibrium instead of waiting for prices and wages to fall and the short-run aggregate supply curve to shift rightward to bring about long-run equilibrium.

· Although Keynes did believe that some savings was necessary for capital accumulation in the economy, savings for the most part undercuts aggregate demand and isn't channeled into the economy.

So, to Keynes, how can aggregate demand be increased to bring about long-run equilibrium? Fiscal policy. Fiscal policy is spending and taxation by the government. Keynes believed that government spending and taxation should follow business cycles.

· If, for example, the economy is recessionary and experiencing less-than-full employment, proper fiscal policy actions should be to increase spending, even going into a budget deficit, and even lowering taxes.

· Because C and I are down in a recession, raising G will help shift aggregate demand rightward, with the "right amount" of government expenditures leading to full employment and long-run equilibrium.

· If, on the other hand, for example, the economy is at full employment and aggregate expenditures are rising, then proper fiscal policy is to reduce spending, even incurring a budget surplus, and raising taxes.

In summary, John Maynard Keynes was considered an authority of economics, sought after by President FDR especially during the Great Depression.

A demand-side economist, the economy can only achieve long-run economic equilibrium if positive or negative demand shocks are used to shift aggregate demand and spending.

· Savings will not be channeled efficiently, waiting for the short-run aggregate supply to catch up will be too slow due to sticky wages and prices, and policies of balancing the budget are ineffective.

· Ultimately, to Keynes, in the long term, establishing policies and automatic stabilizers will shorten the duration of recessions and ensure periods of heated inflationary times will be mitigated.

Demand-Side Strategy

In Week #6 Lecture #1, we discussed the Great Depression, Keynesian economic model, and fiscal policy as a corrective economic tool for business cycle activity.

Keynes was a demand-side economist who theorized the economy can only achieve long-run economic equilibrium if positive or negative demand shocks are used to shift aggregate demand and spending.

· Savings will not be channeled efficiently, waiting for the short-run aggregate supply to catch up will be too slow due to sticky wages and prices, and policies of balancing the budget are ineffective. Modern supply-siders believe in concentrating on aggregate supply rather than demand to ensure economic stability and expansion.

Is a demand-side strategy better to use than a supply-side one? Or, is a supply-side strategy better than a demand-side strategy?

· It may come down to neither is necessarily going to be best on its own without the other. A demand-side strategy will mainly affect aggregate demand by raising or lowering government spending and borrowing and/or lowering or raising marginal tax rates.

· The supply-side strategy will entail a softer marginal tax-rate policy, particularly for higher-end income earners to increase investment and shift aggregate supply.

What effect does a change in marginal tax rates have on the economy? Both quantity demanded and quantity supplied are affected by taxes.

Thus, if marginal tax rates are raised, then the aggregate demand and aggregate supply curves will shift leftward, and depending upon what the effect is on each, output will fall, with price indeterminate.

Lower relative marginal tax rates will tend to increase both aggregate demand and aggregate supply, but during cyclical downturns, more urgency will typically be needed for aggregate demand. Hence, tax cuts with effective government expenditures will positively impact aggregate demand and aggregate supply.

In summary, there is no exact remedy to an ailing economy or overheated economy. Demand-siders believe in affecting aggregate demand with more government spending and less relief to higher-earning income groups than lower ones, while supply-siders want to concentrate more on aggregate supply and tax cuts on higher-earning income groups to generate the needed impact on the economy.

While each has merit, a combination of both is likely going to prove best, whereby marginally higher or lower rates of government spending occur in specific areas of the economy, such as infrastructure (roads, bridges) and lower or higher marginal tax rates are imposed; recessions and downturns imply higher government spending and lower marginal tax rates, while expansions and peaks imply less government spending and possible higher marginal tax rates, particularly for an overheated economy experiencing full employment, increasing aggregate demand, and inflation.

Crowding out and higher interest rates can ensue if too much government spending transpires.