fiscal

a federal deficit' Note that a contractionary fscalpolicy

nirrs to close an exPansionary gaP'

The $hEuBtiBlBeE and the Tfrme F{orfizsm

in the long run $ zero'

classical econorrtiSts a grsrrp ef 18th- an"-i '!Sti?-s*iltilrY ecs$$-

n-?:5t3 wh* believeC fhat

ee;:n*nriu d*wntursrs t.jtl*ctct! th e?lt5s lves thr*uqh natulal n'!arker farces; thus.:it*Y ileliev€d the eccn0lnV was self-enrrecting anct

*eer!*ei no g*seri!rfi **1

!nterv*nt!at't

The proper execution of cl -.-nr1r ;;;J";6nary and contractlonal) , h?5;i;;1i;i;" assurnes that: .. , i=

11

e potenrial0utputisaccuratelygaugeq: ' ' , i* 8 the retevant spending.multiplier can be pred|cled

accuratery ; 2

I ' . aggregate demand can ne ifiitteO bt iusi the right ayount -

t ? ' : 'r r : ' I.'

cansomehilw coordinate their i -Ho valisui glvemrnenLe*t!

' e)

':liseal.ei{otts-: '' : ,, i o the shape 0f the short-run agsregate t',Plll::ft

is known :- ;;l;#.i-t unaffected bv the fiscal policv itsen'

lBtAt\-1iii;;',iFui\GiL*H-i; , T"lf-:.f*l

t

I

:1."i1

n .h l'' ':,.:;'Tl:"-'.::4 .in" ),\ti-Jt1-' "

{ 3

e"t;"?

'E-t *.l .'i

;:t't ,tr

ffi hi..I :t*i

E H

'r r' "61;.,

;-',-.f,.?' '

,... .i::r;'

#@ ':iia

',:t'"

i i ! t ?ti i:

t

L03 Th* Evmiuti*r: *f Fi*e s3 F*3ieY bJow that yau have sorrle

idea of how fiscal po1*

icv can u'ork in th";t' let's take. a iaok at fiscal

IJtn" 1"' Jrr*,i.*, uugitt"i"g wich the approach

Lsed-before the Great Depresston'

Pr'aor ts the Gneat SePressFern Before the r93os, discretionary

fisca1 policy was se1-

dom used to l'-'n'-t""t" th" 'n"t'o"conomy' Pubiic

;it.t-;; ,l'up"a uf-tr'" views.of 'l'"tti:* econo"

mists, who advoca'li'1o"tn'-Joire' the beiief that

;;;"t*";s were the best way to l+i"* economlc

orosperity. ciassicat "eco''o*ittt

did not deny that

Ltt:;t;;t; high unemplovment occurred from

time to time, but tft"V'"tgi"i that the sources of

such crises t"y ot"'iiu th'" *"'k"t :f5*' in the

effectsofwars,taxincreases'poorgowingseasons' changing tastes, "";';l;

like' such external shocks

could reduc" o"tnt'i "^a "*pt"y*"ltl-b,tt classical

economists u"rl"t'"a tT-'"i tl-uC'"i *utket forces' such

as changes i'' p'it"'' *lg"t' ""a interest rates' could

correct these Problems' '" ""'*oiu oli ::lT :';X\ ;TJ:TIIJ,f, :$ ;1 ?l i: the economy's Prrce I(

was produced, prices would fall until the quantlty

]"*i'ff " ;;;iil i]:"1r:\f '_i:Tli,* i: Y"-;;

H:: JT"lisi"li J#ffi: il;;'; ;t il'-".: suppiied :"";;;;ilqt'""titv a"*anded' And

if the interest

;1" ;;iigi' t" ii*'i "u that had been saved'

interest rates would;;ii;;iii the amount invested

"q"uf"a the amount saved'

So the classrcai upp'o"ttt i*plied that natural mar-

ket forces, through fl'exible prices' wages) and inter-

est rates, would *o"" th" "to"o*y toward potential

.rn the short run, the aggregate- supp!

-curve s10pes ;

upward, so a shift of 'ffigui" demand crha'rgtes tretJr

the price levei and tt-'"e"1tti"r of output' wlen aggre-

#"?;''' ;::"11",:i,*,**tf;*X'"'ff11 i A*Tiru]"JilXl"ir;;;" "i"q"iiiu'ium

o"tpui in i the short run depenas o'''tf'" stelpness

ofthe aggre- :

gui",.,pprv..,*Iuj .x5*"::'j"ff:ilff"li*X i ;ff:*:;#:ffiffi;;;l"io*'upptv'u"n'

ih' 1"'', tmpacl a givenshrJt oJ ')''n

ois"S*" d'emand curvehas on i

real GDP andthe ^"'i^i"'li-ti.;* *the price leuel' so

i'tiu' ,iott , the spending multiplier' -:.,^i-a irc nnrpn- i'"" ;;';; *to*y ii already producrng

its poten- I

tial, then in the t"r '""'-#:il::"t":::"1'ff:T:tt:: i :l?$";;T';;;ffic dema"d increases'

the p'ce

i#il#, "ot "nltt output' Thus' if the economv

is already producingn' fotnntiof' the spending multiplier

i i : ?

i i t

! t t

: i

The exact change of

equilibrium outPut in the

short run depends on the steePness of the aggregate suPPlY

curve.

174 PART 3 f iricai atlti idorrerarY PolrrrY

GDP. There appeared to be no need for government intervention. What's more, the government, like househoids, was expected to live within its means. The idea of govemment running a deficit was con- sidered immoral. Thus, before the onset of the Great Depression, most economists believed that discre- tionary fiscal poliry could do more harm than good. Besides, the federal government itself was a bit player in the economy. At the onset of the Great Depression, for exampie, federal outlays were less than 3 percent of GDP (compared to about z4 percent today).

The Great ffiepressE##r end ffifon&d War E$ Although classical economists acknowledged that capitalistic, market-oriented economies could expe- rience high unemployment from time to time, the depth and duration of the depression strained belief in the economy's abiiity to mend itself. The Great Depression was marked by four consecutive years of contraction during which unempioyment reached z5 percent. Investment plunged 8o percent. Many facto- ries sat idle. With vast unemployed resources, output and income fell well short of the economy's potential.

The stark contrast between the natural market I adjustments predicted by classical economists and ! the years of high unemployment during the Great g Depression represented a collision of theory and $ fact. in 1936, John Maynard Keynes of Cambridge H University, England, published The General Theory I of Employment, Interest, and Money, a book that chal- fr tenged the classical view and touched off what would fr later be calied the Keynesian revolution. Keynesian 2 theory and palicy were developed in response to the prob- ), Iem of high unemployment during the Great Depression. .' Keynes's main quarrel with the classical economists 5 was that prices and wages did not seem to be flexible o enough to ensure the full employment of resources.

d ;t

'l

According to Keynes, prices and wages were rela- tively inflexible in the downward direction-they were "sticky"-so natural market forces wouid not return the economy to full employment in a timely fashion. Keynes also believed business expectations might at times become so grim that even very low interest rates would not spur f,rms to invest all that consumers might save.

It is said that geologists learn more about the nature of the Earth's crust from one major upheaval, such as a huge earthquake or major volcanic erup- tion, than from a dozen lesser events. Likewise, economists learned more about the economy from the Great Depression than from many more-modest business cycles. Even though this depression began about eight decades ago, economists continue to sift through the rubble, looking for clues about how the economy realiy works.

Three developments in the years following the Great Depression bolstered the use of discretion- ary fiscal poliry in the United States. The first was the influence of Keynes's General Theory, in which he argued that natural forces would not necessariiy close a contractionary gap. Keynes thought the econ- omy could get stuck well below its potential, requir- ing the government to increase aggregate demand to boost output and employment. The second develop- ment was the impact of World War II on output and employment. The demands of war greatly increased production and erased cyclical unemployment dur- ing the war years, pulling the U.S. economy out of its depression. The third development, Iargeiy a consequence of the first two, was the passage of the H;rrplayment A{t of :945, which gave the fed- erai government responsibility for promoting full employment and price stabiiity.

Prior to the Great Depression, the dominant fiscal policy was a balanced budget. Indeed, to head off a modest deficit in 1932, federal tax rates were raised, which only deepened the depression. In the wake of Keynes's General Theory and World War II, however, policy makers grew more receptive to the idea that Sscal poliry could improve economic stability. The objective of fiscal poliry was no longer to baiance the budget but to promote full employment with price stability even ifbudget deficits resulted.

Autematse Stcb$Efreers

This chapter has focused mostly on discretionary fis- cal policy-conscious deci- sions to change taxes and

Employment Act of rga6 law that assigiled t{] the federal govr:rn*reni the responsibility for pro- rnoting full eFlpl6yr"nent ancl priee stability

C]{AFTIR r: ii:;cai Pclicir 175

government spending to achieve the economy's potential output. Now let's get a clearer picture of automatic stabilizers. Automatic stabilizers smooth out JTuctuations in disposable income over the business cycle by stimulating aggregate demand during recessions and dampening aggregate demand during expansions. Consider the federal income tax. For simplicity, we have assumed that net taxes are independent of income. In reality, the federal income tax system is progressive, meaning that the fraction of income paid in taxes increases as a taxpayer's income increases' During an economic expansion, employment and incomes rise, moving some taxpayers into higher tax brackets. As a result, taxes claim a growing frac- tion of income. This slows the growth in disposabie income and, hence, slows the growth in consumption. Therefore, the progressive income tax relieves some of the inflationary pressure that might otherwise arise as output increases during an economic expan- sion. Conversely, when the economy is in recession, outpur dec.lirre-", e-mploymenf and jncomes fal!. mov-

The Economy

Progressive lncome Tax

Welfare Benefits

176 PART 3 Frscel arrd lloneiary Pclrcv

ing some people into lower tax brackets. As a result, taxes take a smaller bite out of income, so disposable income does not fall as much as GDP. Thus, the pro- gressive income tax cushions declines in disposable income, in consumption, and in aggregate demand.

Another automatic stabilizer is unemployment insurance. During economic expansions, the system automatically increases the flow of unemployment insurance taxes from the income stream into the unemployment insurance fund, thereby moderating consumption and aggegate demand. During con- tractions, unempioyment increases and the system reverses itself. Unemployment payments automati- cally flow from the insurance fund to the unem- ployed, increasing disposable income and propping up consumption and aggregate demand. Likewise, welfare payments automatically increase during hard times as more people become eligible. Because of these automatic stabilizers, GDP fluctuates less than it otherwise would, and disposable income varies pro- portionateiy less than does GDP. Because disposabie income varies less than GDP does, consumption aiso fluctuates less than GDP does.

The progressive income tax, unemploymentinsur- ance, and welfare benefits were initially designed not so much as automatic stabiiizers but as income redis- tribution programs. Their roles as automatic stabilizers were secondary effects of the legislation. Automatic stabilizers do not eliminate economic fluctuations, but they do reduce their magnitude. The stronger and more effective the automatic stabilizers are, the iess need for discretionary fiscal poliry' Because of the greater influence of automatic stabilizers, the economy is more s tabie to d ay lh an it w as dur ing lhe Gr e at D epre s s ion

andbefore. As a measure of just how successful these automatic stabilizers have become in cushioning the impact of recessions, consider this: Between r948 and zoo8, real GDP deciined during seven years, but real consumption fell during only two years-by o.8 per- cent in ry74andby o.3 percent in r98o. Real consump- tion deciined in only two of the last 6o years. Without much f anf are, qutomatic stabilizer s hav e b een quietly doing their work,keeping the economy on a more evenkeeT.

Freirn the €olden Age to Stagflation The i96os was the Golden Age of fiscal poliry. )ohn F. . Ketile{1 Nas $et\\s\presi{eltto praQsse a {ederal t- budget defrcit to stimulate an economy experlenc- ! ing a contractionary gap. Fiscal policy was also used p

o\ occas\or\ to pro.rite a\ extra kick to arr expan- ! sion already under way, a$ in lg6+, when Kennedy's $ successor, iyndon B. /ohnson, cut income tax rates 5 to keep an expansion alive. This tax cut, introduced to e