Unit 7 Macroeconomics:Taxes, Fiscal, and Monetary Policies

Chapters 15.2

EconomicsMr. Biggs

Classical Economics Classical economics - The idea that free markets can regulate themselves.Adam Smith proposed the idea of an “invisible hand” and stated that in a free market, people act in their own self-interest which causes prices to rise or fall.Supply and demand will always return to equilibrium, but the Great Depression highlighted the problem that classical economics did not address how long it would take to reach equilibrium.

Fiscal Policy Options

Keynesian EconomicsJohn Maynard Keynes developed a new theory of economics to explain the Great Depression and give the government a tool to use in the short run.

A Broader ViewKeynes looked at the productive capacity of the whole economy. Productive capacity or full-employment output - The maximum output an economy can produce without causing inflation.He concluded that the only way to end the Great Depression was if someone started spending money.

A New Role for GovernmentKeynesian economics - A form of demand-side economics that encourages action to increase or decrease demand and output.Demand-side economics - The idea that government spending and tax cuts help an economy by raising demand. Keynes believed that government interventions can make up for economic changes caused by businesses or individuals.Keynesian economics proposes that by using fiscal policy the government can, and should, help the economy.

Avoiding Recessions and DepressionsKeynes argued that fiscal policy can be used to fight two fundamental macroeconomic problems:

Recession/depressionInflation

If economic indicators decrease, the government can raise governmental spending and/or cut taxes (expansionary fiscal policies).

Controlling InflationKeynes argued that the government could use contractionary fiscal policies to prevent inflation or reduce its severity.For example, reducing governmental spending and/or raising taxes.

The Multiplier EffectMultiplier effect - The idea that every one dollar of government spending creates more than one dollar in economic activity.For example, if the government decides to spend money to stimulate the economy, businesses would spend their additional earnings on infrastructure, wages, raw materials, and investment. Those recipients will spend a part of this money, then those recipients will spend a part of that money, etc.When all the rounds of spending are added up, the initial government spending may have a 3-fold increased effect on GDP.

Automatic StabilizersThe use of federal taxes and spending on transfer payments, two key parts of fiscal policy, are used to keep the economy stable and are known as automatic stabilizers.Automatic stabilizer - A government program that changes automatically depending on GDP and a person’s income.When national income is high, the government collects more taxes and pays out less in transfer payments (takes money away from consumers).This decrease in spending balances out the increase in spending that results from rising income.The opposite is also true.When national income is low, the government collects less in taxes and pays out more in transfer payments (gives money to consumers).This increase in spending balances out the decrease in spending that results from decreasing income.

Supply Side EconomicsSupply side economics - A school of economics that believes tax cuts can help an economy by raising supply.

The Laffer CurveThe Laffer Curve illustrates the relationship between the tax rate set by the government and the total tax revenue that the government collects.High tax rates may not bring in much revenue if these high tax rates cause economic activity to decrease.For example, in the extreme case of 100% taxation, no one would want to work.

Taxes and OutputSupply-side economists believe that a tax cut increases total employment so much that the government actually collects more in taxes at the new, lower tax rate.Historically, taxpayers do not react strongly enough, by working more hours, to tax cuts to increase tax revenue.

Fiscal Policy in American HistoryPresident Hoover, influenced by classical economics, thought the economy was sound and would return to equilibrium.President Roosevelt, influenced by Keynesian economics, was more willing to increase government spending to help lift the economy out of depression.

World War IIKeynesian policies were fully tested in the United States during WWII and proved to be successful.Council of Economic Advisors (CEA) - A group of three respected economists formed after WWII that advise the President on economic policy.

The Kennedy AdministrationPresident Kennedy inherited a recession when he took office, so he cut the historically high taxes and over the next two years, the economy grew rapidly as predicted by Keynesian economists.

Supply-Side Policies in the 1980sPresident Reagan instituted new policies based on supply-side economics and cut taxes by 25%.After 1982, the economy recovered and flourished, but the government spent more money than it took in creating large federal deficits.

The End