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Fiscal Policy: The Keynesian View and the Historical Development of Macroeconomics

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by: James Gwartney & Charles Skipton

Full Length Text —

Macro Only Text —

Part: 3

Chapter: 11

First page

The Historical Evolution of Macroeconomics

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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.

Several of the basic concepts of macroeconomics and much of the terminology were initially introduced during the 1930s.

Keynesian economics was also an outgrowth of the Great Depression.

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Keynesian Economics: A Historical Overview

John Maynard Keynes was probably the most influential economist of the 20th Century.

Keynes developed a theory that provided both an explanation for the prolonged unemployment of the 1930s and a recipe for how to generate a recovery.

Keynesian analysis indicated that fiscal policy could be used to maintain a high level of output and employment.

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Keynesian Economics: A Historical Overview

The Keynesian view dominated macroeconomics for the 3 decades following WWII.

Keynesian economics began to wane during the 1970s because it was unable to explain the simultaneous occurrence of high unemployment and inflation.

But, the severe recession of 2008-2009 generated renewed interest in Keynesian analysis.

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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 Great Depression and the Macro-adjustment Process

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The Great Depression and the Macro-adjustment Process

Prior to the Great Depression, most economists thought market adjustments would direct an economy back to full employment rather quickly.

The Great Depression’s length & severity changed these views.

The depth and length of the economic decline during the 1930s is difficult to comprehend.

Between 1929 and 1933, real GDP fell by more than 30%.

In 1933, nearly 25% of the U.S. labor force was unemployed.

The depressed conditions continued. In 1939, a decade after the plunge began, the rate of unemployment was still 17% and per-capita income was virtually the same as a decade earlier.

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The Great Depression and Keynesian Economics

Keynes provided an explanation for the prolonged depressed conditions of the 1930s.

He argued that spending motivated firms to produce output.

If spending fell because of pessimism and other factors, firms would reduce production.

When an economy is in recession, Keynesians do not believe that reductions in either resource prices or interest rates will promote recovery.

As a result, market economies are likely to experience recessions that are both severe and lengthy.

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The Keynesian Concept of Equilibrium

In the Keynesian model, firms will produce the amount of goods and services they believe people plan to buy.

Equilibrium occurs when total spending equals current output. When this is the case, producers have no reason to expand or contract output.

If total spending (demand) is deficient, depressed conditions and high levels of unemployment will persist.

This is precisely what Keynes believed happened during the 1930s.

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The Keynesian Concept of Equilibrium

If total spending is less than full employment output, inventories will rise and firms will reduce output and employment.

The lower level of output and employment will persist as long as total spending is less than output.

Total spending (AD) is key to the Keynesian macroeconomic model.

Keynes believed that the cause of the Great Depression was weak AD – deficient total spending on goods and services.

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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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The Multiplier Principle

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).

Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until …

Marginal propensity to consume

3/4

Additional income (dollars)

Additional consumption (dollars)

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

4,000,000

3,000,000

effectively, $4 million is spent in the economy.

Expenditure

stage

Round 1

Round 2

Round 3

Round 4

Round 5

Total

All others

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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:

MPC

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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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Adding Realism to the Multiplier

In evaluating the importance of the multiplier, remember:

An increase in government spending will require either higher taxes or additional government borrowing.

This will often generate secondary effects, reducing spending in other areas.

It takes time for the multiplier to work.

The multiplier effect implies the additional spending brings idle resources into production without price changes -- unlikely to be the case during normal times.

During normal times, the demand stimulus effect of additional spending is substantially weaker than the multiplier suggests.

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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 principle explains why these fluctuations are magnified.

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The Keynesian View of Fiscal Policy

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Budget Deficits and Surpluses

A budget deficit is present when total government spending exceeds total revenue from all sources.

When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows by issuing bonds.

A budget surplus is present when total government spending is greater than total revenue.

Surpluses reduce the magnitude of the government’s outstanding debt.

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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

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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, most 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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Keynesian Policy to Combat Recession

When an economy is operating below its potential output, the Keynesian economic model suggests that fiscal policy should be more expansionary.

increase in government purchases of goods & services

or reduction in taxes

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Expansionary Fiscal Policy

At e1 (Y1), the economy is below its potential capacity YF .

There are 2 routes to long-run full-employment equilibrium:

Goods & Services (real GDP)

Price Level

Rely on lower resource prices to reduce costs and increase supply to SRAS2, restoring equilibrium at YF (E3).

Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and direct the economy back to YF (E2).

AD1

LRAS

AD2

Expansionary fiscal policy stimulates demand and directs the economy to full-employment.

SRAS1

SRAS2

Keynesians believe that

allowing the market to

self-adjust may be a lengthy

and painful process.

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Keynesian Policy To Combat Inflation

When inflation is a potential problem, Keynesian analysis suggests fiscal policy should be more restrictive:

reduction in government spending

or increase in taxes

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Restrictive Fiscal Policy

Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential YF.

Goods & Services (real GDP)

Price Level

If maintained, the strong demand will lead to the long-run equilibrium E3 at a higher price level (SRAS shifts to SRAS2).

Restrictive fiscal policy could reduce demand to AD2 (or keep AD from shifting to AD1 initially) and lead to equilibrium E2.

Restrictive fiscal policy restrains demand and helps control inflation.

AD1

LRAS

AD2

SRAS2

SRAS1

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Keynesian View of Fiscal Policy: A Summary

The federal budget is the primary tool of fiscal policy.

Keynesians stress the importance of counter-cyclical policy.

The budget should shift toward deficit when the economy is threatened by recession.

The budget should shift toward surplus when inflation is a threat.

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Questions for Thought:

What is the multiplier principle? Does the multiplier principle make it more or less difficult to stabilize the economy? Explain.

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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Fiscal Policy Changes and Problems of Timing

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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 and 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.

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Problems with Proper Timing

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, it may increase economic instability.

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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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Savings, Spending, Debt, and the Impact of Fiscal Policy

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Paradoxes of Thrift and Spending

The paradox of thrift:

The idea that when a large number of households increase their saving and reduce consumption, their actions may reduce aggregate consumption and throw the economy into a recession.

Keynesians often stress the dangers implied by the paradox of thrift and excessive saving.

The paradox of thrift indicates that efforts to save more could reduce the overall demand for goods and services, causing businesses to reduce output and lay off workers.

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Paradox of Excessive Consumption

While an increase in consumption might temporarily boost AD, households will face financial troubles if they save little and spend most of what they earn and borrow on current consumption.

Even though the incomes of Americans are the highest in history, so too is their financial anxiety.

You cannot have a strong and healthy economy when households are heavily indebted and face persistent financial troubles because their saving rate is low.

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Household Debt as a Share of After-Tax Income, 1960-2012

The household debt to income ratio of Americans has increased steadily since the mid-1980s.

The debt to disposable income ratio of households soared to 130% in 2007, approximately twice the level of the 1960s and 1970s.

Household Debt as a Share of After-Tax Income

1960-2012

1960

1964

1972

20%

40%

60%

80%

100%

120%

140%

1968

1976

1984

1980

1992

2000

1996

2008

2004

1988

2012

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Household Debt and the 2008-2009 Recession

The historically high level of debt meant households were in a weak position to deal with the recession of 2008-2009.

As a result of the their high debt/income ratio, households were reluctant to spend additional income.

Thus the Keynesian tax rebates and federal spending increases of the Bush and Obama administrations were largely ineffective.

Even with budget deficits of 10% of GDP, output was sluggish and unemployment remained high in 2009-2012.

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Questions for Thought:

Why is the proper timing of changes in fiscal policy so important? Why is it difficult to achieve?

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.

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Questions for Thought:

3. When households are heavily indebted, what are they likely to do with an unexpected increase in income such as a tax rebate? How will this impact the effectiveness of expansionary fiscal policy?

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End of

Chapter 11

First page