Fiscal Policy

 

Classical Economics

1. Classical economics, which originated in 1776 with Adam Smith’s Wealth of Nations, was the dominant economic thinking until the mid-1850s.

2. Uses a laissez-faire approach, meaning the government should not interfere in the market because the market can regulate itself.

3. Economists should focus on how to encourage savings and investment in order to increase economic growth over the long term.

 

Keynesian Economics and Fiscal Policy

Fiscal policy refers to a government’s attempts to manage aggregate demand.

1. John Maynard Keynes published The General Theory of Employment, Interest, and Money in 1936.

2. Keynes’s focus was on short-run economic issues. He agreed with the classical approach only for when the economy is at potential output. The general theory he spoke of was that when the economy is not producing at full output, laissez-faire approaches will not work, because the economy can get stuck in a rut, as was happening at the time with the Great Depression.

3. The Paradox of Thrift: Keynesians point out that savings will not always equal investment. If there is a recession, then there is great uncertainty about what will happen in the future, causing firms to reduce their investment plans. When savings do not translate into investment, the aggregate expenditures in the economy are reduced by new savings, which moves the economy further into a recession.

4. The classical economists would let wages drop because they assume that all other things are equal, but Keynes points out that all other things are not equal since a decrease in wages leads to a decrease in income, which leads to decreased aggregate demand, which means decreased production from firms, which means less output and even more unemployment.

5. Keynes argued that in order to get out of recessions and have any chance for long-term economic growth, the government must take an active role in encouraging aggregate demand, by increasing government spending or decreasing taxes.

 

Critiques of Fiscal Policy

1. Congress is too slow to act. Government policies often come too late.

2. Crowding out effects: It is possible that a change in government expenditures could be offset by a change in private expenditures in the opposite direction.

3. Real business cycle critique: Increases in aggregate demand are only going to lead to inflationary gaps, since they are an artificial component of the economy, and so inflation will result, but nothing real will change (like the output or unemployment rate).

4. Public choice critique: Politicians are interested in being reelected. Expansionary fiscal policy is a popular political move, but the unpopularity of contractionary fiscal policy (raising taxes or cutting spending) makes it difficult to enact. Fiscal policy cannot be effective if it is only used in one direction.

5. Supply side economics critique: Taxes and government spending negatively affect people’s incentives to work, save, and invest. The economy would grow faster if the government were scaled back.