Macroeconomics

· The English economist John Maynard Keynes developed a model that provided an explanation for the high and prolonged rate of unemployment of the Great Depression.

· In the Keynesian model, equilibrium occurs when the spending on consumption, investment, government purchases, and net exports is equal to total output. Firms will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners plan to buy. If this spending level is less than full-employment output, firms will not alter their production levels and the less than full-employment rate of output will persist. Keynes believed this was the situation during the Great Depression.

· According to the Keynesian view, fluctuations in total spending (aggregate demand) 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.

· When an economy is in a 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.

· The federal budget is the primary tool of fiscal policy. The Keynesian model highlights the use of fiscal policy as a tool with which to maintain demand at a level consistent with full employment and price stability.

· Rather than balancing the budget annually, Keynesians believe that fiscal policy should reflect business cycle conditions. During a recession, fiscal policy should become more expansionary (a larger deficit should be run). During an inflationary boom, fiscal policy should become more restrictive (shift toward a budget surplus).

· Changes in fiscal policy must be timed properly if they are going to exert a stabilizing influence on an economy. The ability of policy-makers to time fiscal policy changes in a countercyclical manner is reduced by

· (1)

the inability of the political process to act rapidly,

· (2)

the time lag between when a policy change is instituted and when it affects the economy, and

· (3)

the inability to forecast accurately the future direction of the economy.

· Automatic stabilizers help promote stability because they are able to add demand stimulus during a recession and restraint during an economic boom without legislative action.

· Although an abrupt increase in saving may exert an adverse impact on the economy in the short run, saving provides the financing for investment that powers long-term growth. Moreover, a healthy economy is dependent on households saving regularly and avoiding excessive debt.