Classical vs.

Keynesian
Economics
Changing the Role of Government
During the Great Depression

Classical Economics
Govt. should not have a role in regulating the
economy

Any economic instability (inflation, unemployment)

would be resolved through the market system

The length and severity of the Great Depression

challenged the laissez-faire approach to economic
stabilization

Keynesian Economics
Developed during the depths of the Great
Depression

Noted that the economy was not producing at its

productive capacity (potential real GDP); fullemployment output not attained

Keynesian Economics
C + I + G + (Xn) = GDP
Firms had no
incentive to make
products that
consumers had no
money to purchase

Demand-side Fiscal Policy

To compensate for lack of
C and I spending, the govt.
can tax and spend to
maintain stable AD & GDP
level.

The Multiplier Effect

Every one dollar change in fiscal policy creates a
greater than one dollar change in spending

In a year, a dollar is spent more than once what

someone earns is spent and then spent again by the
recipient

National Government

Mandatory Spending

Direct Economic Consequences

(Fiscal Policy)

Discretionary Spending
Indirect Economic Consequences

Automatic Stabilizers
govt. programs that automatically react to

stabilize the economy

Taxes & transfer payments react to changes in
real GDP
Ex: during a recession, tax revenues and transfer
payments to stimulate spending (AD)
Transfer payments government cash payments to
firms and households for which no good or service is
received in exchange (subsidies, welfare,
unemployment benefits, etc)