Fiscal Policy: The Keynesian View and Historical Perspective

Fiscal Policy: The
Keynesian View and

Historical Perspective
Full Length Text — Part: 3 Chapter: 11
Macro Only Text — Part: 3 Chapter: 11
To Accompany “Economics: Private and Public Choice 13th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by:
Joseph Connors, James Gwartney, & Charles Skipton
Copyright ©2010 Cengage Learning. All rights reserved.

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The Great Depression and
Macroeconomics
• The Great Depression exerted a huge impact
on macroeconomics.
• The national income accounts that we use to
measure GDP were developed during this era.
• Several of the basic concepts of
macroeconomics and much of the
terminology were initially introduced during
the 1930s.
• Keynesian economics was also an outgrowth
of the Great Depression.

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Keynesian Economics: A Historical
Overview
• John Maynard Keynes was probably the most
influential economist of the 20th Century.
• Keynes developed a theory that provided both
an explanation for the prolonged
unemployment of the 1930s and a recipe for
how to generate a recovery.
• Keynesian analysis indicated that fiscal policy
could be used to maintain a high level of
output and employment.

Keynesian Economics: A Historical
Overview
• The Keynesian view dominated
macroeconomics for 3 decades following
WWII.
• Keynesian economics began to wane during
the 1970s because it was unable to explain the
simultaneous occurrence of high
unemployment and inflation.
• But, the severe recession of 2008-2009
generated renewed interest in Keynesian
analysis.

Game Plan for Analysis of Fiscal
Policy
• This chapter will present the Keynesian view
of fiscal policy and consider how it has
evolved through time.
• The next chapter will focus on alternative
theories and consider incentive effects that are
largely ignored within the Keynesian
framework.
• Taken together, these two chapters provide a
balanced presentation of current views on the
potential and limitations of fiscal policy as a
stabilization tool.

The Great Depression
and the Macroadjustment
Process

The Great Depression and the
Macroadjustment Process
• Prior to the Great Depression, most
economists thought market adjustments
would direct an economy back to full
employment rather quickly.
• The length and severity of the Great
Depression changed these views.

The Great Depression and the
Macroadjustment Process
• The depth and length of the economic decline
during the 1930s is difficult to comprehend
• Between 1929 and 1933, real GDP fell by
more than 30%.
• In 1933, nearly 25% of the U.S. labor force
was unemployed.
• The depressed conditions were prolonged. In
1939, a decade after the plunge began, the rate
of unemployment was still 17% and per-capita
income was virtually the same as a decade
earlier.

The Great Depression and
Keynesian Economics
• Keynes provided an explanation for the
prolonged depressed conditions of the 1930s.
• He argued that spending motivated firms to
produce output.
• If spending fell because of pessimism and
other factors, firms would reduce production.
• When an economy is in 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. Copyright ©2010 Cengage Learning. All rights reserved.
The Keynesian Concept of
Equilibrium
• In the Keynesian model, firms will produce
the amount of goods and services they believe
people plan to buy.
• Equilibrium occurs when total spending
equals current output. When this is the case,
producers have no reason to expand or
contract output.
• If total spending (demand) is deficient,
depressed conditions and high levels of
unemployment will persist.
• This is precisely what Keynes believed
happened during the 1930s.
The Keynesian Concept of
Equilibrium
• If total spending is less than full employment
output, inventories will rise and firms will
reduce output and employment.
• The lower level of output and employment
will persist as long as total spending is less
than output.
• Total spending (AD) is key to the Keynesian
macroeconomic model.
• Keynes believed that the cause of the Great
Depression was weak AD – deficient total
spending on goods and services.

The Multiplier Principle
• The concept that an independent change in
expenditures (such as investment) leads to
an even larger change in aggregate output.
• The multiplier concept builds on the point
that one individual’s spending becomes the
income of another.
• Income recipients will spend a portion of
their additional earnings on consumption.
In turn, their consumption expenditures will
generate additional income for others who
also spend a portion of it.
• Thus, growth in spending can expand output
by a multiple of the original increase.

The Multiplier Principle (Exhibit 1)
Expenditure Additional income Additional consumption Marginal propensity
stage (dollars) (dollars) to consume
Round 1 1,000,000 750,000 3/4
Round 2 750,000 562,500 3/4
Round 3 562,500 421,875 3/4
Round 4 421,875 316,406 3/4
Round 5 316,406 237,305 3/4
All others 949,219 711,914 3/4
Total 4,000,000 3,000,000 3/4
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
• The multiplier concept is fundamentally based upon the
proportion of additional income that households choose to
spend on consumption: the marginal propensity to consume
(here assumed to be 75% = 3/4).
• Here, a $1,000,000 injection is spent, received as payment,
saved and spent, received as payment, saved and spent …
etc. … until … effectively, $4 million is spent in the economy.
The Multiplier Principle
• The term multiplier is also used to indicate
the number by which the initial change in
spending is multiplied to obtain the total
increase in output.
• In the previous example, a $1 million initial
increase in spending expanded output by a
total of $4 million. Thus the multiplier was 4.
• The size of the multiplier increases with the
marginal propensity to consume (MPC).
• Specifically the relationship between the MPC
and the multiplier follows this equation:
1
M = 1 - MPC
The Multiplier and Economic
Instability
• The multiplier concept also works in reverse –
reductions in spending will also be magnified
and generate even larger reductions in
income.
• Even a minor disturbance may be amplified
into a major disruption because of the
multiplier.
• Keynesians argue that the multiplier concept
indicates that market economies have a
tendency to fluctuate back and forth between
excessive demand that generates an economic
boom and deficient demand that leads to
recession. Copyright ©2010 Cengage Learning. All rights reserved.
Adding Realism to the Multiplier
• In evaluating the importance of the multiplier,
one should remember:
• An increase in government spending will
require either higher taxes or additional
government borrowing.
• This will often generate secondary effects,
reducing spending in other areas.
• It takes time for the multiplier to work.
• The multiplier effect implies that the
additional spending brings idle resources into
production without price changes -- this is
unlikely to be the case during normal times.
• During normal times, the demand stimulus
effect of additional spending is substantially
weaker than the multiplier suggests.
Keynes and Economic Instability:
A Summary
• According to the Keynesian view, fluctuations
in total spending (AD) 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.

The Keynesian View
of Fiscal Policy

Budget Deficits and Surpluses
• Budget deficit:
present when total government spending exceeds
total revenue from all sources
• When the money supply is constant, deficits
must be covered with borrowing. The U.S.
Treasury borrows by issuing bonds.
• Budget surplus:
present when total government spending is
greater than total revenue
• Surpluses reduce the magnitude of the
government’s outstanding debt.

Budget Deficits and Surpluses
• Changes in the size of the federal deficit or
surplus are often used to gauge whether
fiscal policy is stimulating or restraining
demand.
• Changes in the size of the budget deficit or
surplus may arise from either:
• a change in cyclical economic conditions
• a change in discretionary fiscal policy
• The federal budget is the primary tool of
fiscal policy.
• Discretionary changes in fiscal policy:
deliberate changes in government spending
and/or taxes designed to affect the size of
the budget deficit or surplus.
Fiscal Policy and the Good News
of Keynesian Economics
• Keynesian theory highlights the potential
of fiscal policy as a tool capable of reducing
fluctuations in AD.
• Prior to the Great Depression, it was widely
believed that the government should balance
its budget. Keynesians challenged this view.
• Rather than balancing the budget annually,
Keynesians argue that counter-cyclical policy
should be used to offset fluctuations in AD.
• This implies that the government should
plan budget deficits when the economy is
weak and budget surpluses when strong
demand threatens to cause inflation.
Keynesian Policy
to Combat Recession
• When an economy is operating below its
potential output, the Keynesian model
suggests that fiscal policy should be more
expansionary.
• increase in government purchases
of goods & services
• or reduction in taxes

Expansionary Fiscal Policy
Price
Level LRAS SRAS1
SRAS2
Keynesians believe that
allowing the market to
self-adjust may be a lengthy
and painful process.
P2 E2
P1 e1 Expansionary fiscal policy
stimulates demand and
P3 E3 directs the economy to
full-employment.
AD1 AD2
Goods & Services
Y1 YF (real GDP)
• At e1 (Y1), the economy is below its potential capacity YF .

There are 2 routes to long-run full-employment equilibrium:
• Rely on lower resource prices to reduce costs and increase
supply to SRAS2, restoring equilibrium at YF (E3).
• Alternatively, expansionary fiscal policy could stimulate
AD (shift to AD2) and direct the economy back to YF (EAll2rights
Copyright ©2010 Cengage Learning.
). reserved.
Keynesian Policy
To Combat Inflation
• When inflation is a potential problem,
Keynesian analysis suggests fiscal policy
should be more restrictive.
• reduction in government spending
• or increase in taxes

Restrictive Fiscal Policy
Price
Level LRAS SRAS2
SRAS1
P3 E3
P1 e1 Restrictive fiscal policy
P2 E2 restrains demand and
helps control inflation.
AD2 AD1
Goods & Services
YF Y1 (real GDP)
• Strong demand such as AD1 will temporarily lead to an

output rate beyond the economy’s long-run potential YF.
• If maintained, the strong demand will lead to the long-run
equilibrium E3 at a higher price level (SRAS shifts to SRAS2).
• Restrictive fiscal policy could reduce demand to AD2 (or keep
AD from shifting to AD1 initially) and Copyright
lead ©2010
to equilibrium E2.
Cengage Learning. All rights reserved.
Keynesian View of Fiscal Policy:
A Summary
• The federal budget is the primary tool of
fiscal policy.
• Keynesians stress the importance of counter-
cyclical policy.
• The budget should shift toward deficit when
the economy is threatened by recession.
• The budget should shift toward surplus when
inflation is a threat.

Questions for Thought:
1. What is the multiplier principle? Does
the multiplier principle make it more or less
difficult to stabilize the economy? Explain.
2. Why did John Maynard Keynes think the high
level of unemployment persisted during the
Great Depression? What did he think needed
to be done to avoid the destructive impact of
circumstances like those of the 1930s?

Fiscal Policy Changes and
Problems of Timing

Problems with Proper Timing
• There are three major reasons why it is
difficult to time fiscal policy changes in
a manner that promotes stability:
• It takes time to institute a legislative change.
• There is a time lag between when a change is
instituted & when it exerts significant impact.
• These time lags imply that sound policy
requires knowledge of economic conditions
9 to 18 months in the future. But, our ability
to forecast future conditions is limited.
• Discretionary fiscal policy is like a
two-edged sword; it can both harm and help.
• If timed correctly,
it may reduce economic instability.
• If timed incorrectly, however,
it may increase economic instability.
Automatic Stabilizers
• Automatic Stabilizers:
Without any new legislative action, these tools
will increase the budget deficit (reduce the surplus)
during a recession and increase the surplus
(reduce the deficit) during an economic boom.
• The major advantage of automatic stabilizers is
that they institute counter-cyclical fiscal policy
without the delays associated with legislative
action.
• Examples of automatic stabilizers:
• unemployment compensation
• corporate profit tax
• progressive income tax
1. Why is the proper timing of changes in fiscal
policy so important? Why is it difficult to
achieve?
2. Automatic stabilizers are government programs
that tend to:
a. bring expenditures and revenues automatically
into balance without legislative action.
b. shift the budget toward a deficit when the
economy slows but shift it towards a surplus
during an expansion.
c. increase tax collections automatically during
a recession.

The Keynesian Aggregate
Expenditure Model

The Keynesian
Aggregate Expenditure (AE) Model
• All models make simplifying assumptions.
• Within the framework of the Aggregate
Expenditure model:
• There is a specific full-employment level
of output.
• Wages and prices are completely inflexible
until full-employment is reached.
• Once full employment is reached, increases
in demand lead only to higher prices.

The Keynesian
Aggregate Expenditure (AE) Model
• In the Keynesian AE model:
• As income expands, consumption increases,
but by a lesser amount than the increase in
income.
• Both planned investment and government
expenditures are independent of income.
• Planned net exports decline as income
increases.
Aggregate Planned Planned
Planned + Planned + government + net
expenditures = consumption investment expenditures exports

Aggregate Consumption Function
Planned consumption
(trillions of $)
45º line
13
Saving
10 C
Dissaving
7
45º Real disposable

income
4 7 10 13 (trillions of dollars)
• The Keynesian model assumes that there is a positive
relationship between consumption and income.
• However, as income increases, consumption increases by a
smaller amount. Thus, the slope of the consumption function
(line C) is less than 1 (less than the slope of the 45° line).
Income and Net Exports
Total output Planned exports Planned imports Planned net exports
(real GDP in trillions) (trillions) (trillions) (trillions)
$13.4 $1.2 $1.00 $0.20

13.7 1.2 1.05 0.15
14.0 1.2 1.10 0.10
14.3 1.2 1.15 0.05
14.6 1.2 1.20 0.00
• Because exports are determined by income

abroad, they are constant at $1.2 trillion.
• Imports increase as domestic income expands.
• Thus, planned net exports fall as domestic income
increases.

Keynesian Equilibrium
• According to the Keynesian viewpoint,
equilibrium occurs when:
Planned aggregate Current
expenditures = output
• When this is the case:
• Businesses are able to sell the total amount
of goods & services that they produce.
• There are no unexpected changes in
inventories.
• Producers have no reason to either expand or
contract their output during the next period.

Total aggregate Current
• When expenditures < output
firms accumulate unplanned additions to
inventories that will cause them to cut back
on future output and employment.
Total aggregate Current
• When expenditures > output
inventories fall and businesses respond with
an expansion in output in an effort to restore
inventories to their normal levels.

• Keynesian equilibrium can occur at less than
the full employment output level.
• When it does, the high rate of unemployment
will persist into the future.
• Aggregate expenditures (demand) are key to
the Keynesian macroeconomic model.
• Keynes believed that weak demand was the
cause of the Great Depression.

An Example of Keynesian Equilibrium
Total Output Planned aggregate Planned Planned investment plus Planned Tendency
(real GDP) expenditures consumption government expenditures net exports of output
$ 13.4 < $ 13.70 $9.1 $4.4 $0.20 Expand
13.7 < 13.85 9.3 4.4 0.15 Expand
14.0 = 14.00 9.5 4.4 0.10 Equilibrium
14.3 > 14.15 9.7 4.4 0.05 Contract
14.6 > 14.30 9.9 4.4 0.00 Contract
Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment
plus Planned Government Expenditures plus Planned Net Exports
• In the Keynesian system, when total output is less than
planned aggregate expenditures, purchases exceed output
and inventories decline. Firms expand their output to rebuild
their inventories to regular levels.
• When output is more than planned aggregate expenditures,
output exceeds purchases, and inventories rise. Firms reduce
output in order to reduce excessive inventories.
• When planned aggregate expenditures equal total output,
there is Keynesian macroeconomic equilibrium.
Aggregate Expenditures
Planned aggregate Equilibrium
expenditures
(trillions of $) (AE = GDP)
10.0
5.0
45º
Output
5.0 10.0 (Real GDP --
trillions of $)
• Aggregate expenditures will be equal to total output for

all points along the 45° line from the origin.
• The 45° line maps out potential equilibrium levels of output
for the Keynesian model.
Planned aggregate
expenditures
(trillions of $) Equilibrium
Unplanned (AE = GDP)
reduction
in inventories
AE = C + I + G + NX
13.85
45º Output
(Real GDP --
13.7 trillions of $)
• At output levels below $14.0 trillion (for example 13.7) AE

is above the 45° line – expenditures exceed output and thus
businesses sell more than they currently produce,
diminishing inventories. Businesses expand output.
Planned aggregate
expenditures
Unplanned (AE = GDP)
reduction
in inventories
AE = C + I + G + NX
14.15
13.85
Unplanned
increase
in inventories
45º Output
(Real GDP --
13.7 14.3 trillions of $)
• At output levels above $14.0 trillion (for example 14.3) AE

is below the 45° line – output exceeds expenditures and thus
businesses sell less than they currently produce, increasing
inventories. Businesses reduce output.
Planned aggregate
expenditures
Keynesian (AE = GDP)
equilibrium
AE = C + I + G + NX
14.15
14.00
13.85
Full Employment
(potential GDP)
45º Output
(Real GDP --
13.7 14.0 14.3 trillions of $)
• Keynesian equilibrium exists where planned expenditures
just equal actual output. Here that point is at $14.0 trillion.
• Full-employment for this example exists at $14.3 trillion. In
the Keynesian model, macroeconomic equilibrium does not
necessarily coincide with full-employment.
Planned aggregate
expenditures AE = GDP
(trillions of $)
AE2
AE1
14.3
14.0
Full Employment
(potential GDP)
45º Output
(Real GDP --
• If equilibrium is less than its capacity, only an increase in

expenditures (shift AE) can lead to full employment output.
• If consumers, investors, governments, or foreigners spend
more and thereby shift AE to AE2, output would reach its
full employment potential. Copyright ©2010 Cengage Learning. All rights reserved.
Planned aggregate
expenditures AS AE = GDP
(trillions of $) AE3
14.6 AE2
AE1
14.3
14.0
Full Employment
(potential GDP)
45º Output
(Real GDP --
• Once full employment is reached, further increases in AE,

such as to AE3, lead only to higher prices – nominal output
expands along the black segment of AE (those points beyond
the full employment output level at $14.3 trillion) but real
output does not. Jump to first page
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Aggregate Expenditure and AD-AS
Models
• The AE model implies that increases in
demand will expand output until full
employment is reached.
• Within the AD-AS model, this implies that the
SRAS curve is horizontal until full
employment is achieved.
• Once full employment is reached, the AE
model implies that additional demand will
lead only to a higher price level.
• Within the AD-AS model, this implies that the
SRAS curve is vertical at the full employment
level of output.
Shifts In Demand, Prices, and
Output
• An important implication of Keynesian
analysis within the AD-AS framework:
• When substantial idle resources are present,
increases in AD will lead primarily to an
expansion in output and the impact on the
general level of prices will be small.
• When an economy is at or near full
employment, increases in AD will lead
primarily to a higher price level rather than a
substantial increase in output.

1. According to the Keynesian view, which of
the following is true?
a. Businesses will produce only the quantity of
goods and services they believe consumers,
investors, governments, and foreigners will
plan to buy.
b. If planned aggregate expenditures are less than
full employment output, output will fall short
of its potential.
c. Equilibrium can only occur at the full
employment rate of output.

2. Within the framework of the Keynesian AE
model, if the planned expenditures on goods
and services were less than current output,
a. business firms would reduce their output and
lay off workers in the near future.
b. the wage rates of workers would decline and
thereby help to direct the economy to full
employment.
3. What changes output in the Keynesian AE
model?

End
Chapter 11


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Fiscal Policy: The

Keynesian View and

To Accompany “Economics: Private and Public Choice 13th ed.”

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

Copyright ©2010 Cengage Learning. All rights reserved.

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• At e1 (Y1), the economy is below its potential capacity YF .

Copyright ©2010 Cengage Learning. All rights reserved.

• Strong demand such as AD1 will temporarily lead to an

Copyright ©2010 Cengage Learning. All rights reserved.

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Copyright ©2010 Cengage Learning. All rights reserved.

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45º Real disposable

$13.4 $1.2 $1.00 $0.20

• Because exports are determined by income

Copyright ©2010 Cengage Learning. All rights reserved.

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Copyright ©2010 Cengage Learning. All rights reserved.

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• Aggregate expenditures will be equal to total output for

• At output levels below $14.0 trillion (for example 13.7) AE

• At output levels above $14.0 trillion (for example 14.3) AE

• If equilibrium is less than its capacity, only an increase in

• Once full employment is reached, further increases in AE,

Copyright ©2010 Cengage Learning. All rights reserved.

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