Fiscal Policy

Government Intervention in the Free Market?

Classical vs. Keynesian

1900 1929

Classical Economics |----------------------------|

Keynesian Economics |----------------------------|

1936 1979

Believed in Self-regulationShort RecessionsPrice Flexible

Believed in Government Intervention

Long RecessionsPrice Sticky

John Keynes 1883-1946

• Argued Government intervention was necessary to moderate the “ups & downs” of business cycle– Recessions could be long or permanent

• Dominated economics after Great Depression– FDR’s New Deal is an example….

GDPGDP

Fiscal Policy Introduction Worksheet

GDPGDP

AD1

LRAS1PriceLevel

RealGDP

SRAS1

-----------P1

Y1

E1---------

2 Types of Fiscal Policy

• Expansionary Policy– Used in recessionary gap

• Contractionary Policy– Used in inflationary gap

Increase Gov’t SpendingDecrease Taxes

Decrease Gov’t SpendingIncrease Taxes

AD =>

AD =>

GDPGDP

Recessionary Gap

Economy below full output Economy above full output

LRAS1PriceLevel

RealGDP

SRAS1

AD1

Inflationary Gap

Expansionary Fiscal PolicyGov’t would lower income taxes => (C↑) Increase Gov’t Spending (G↑)

End result: AD shifts right, debt rises

Contractionary Fiscal PolicyGov’t would raise income taxes => (C↓)Decrease Gov’t Spending (G↓ )

End result: AD shifts left, debt falls

------------------P1

Y1

-----------------

E1