Download Booms and busts, the accelerator, and Keynesian fiscal policy

Free-response/problem
1. Define budget deficit and
government debt.
2. Evaluate whether governments
should employ income tax systems
that are progressive or proportional
(flat).
Booms and Busts
What causes economic volatility?
• Case study: What caused the Great
Depression?
1. Keynes: Accelerator model
2. Neoclassical: Money supply
3. Classical: Theory of malinvestment
Accelerator Model (Keynesian)
• Keynesians believe that investment (I) demand
is not sensitive to the interest rate, instead it is
primarily linked to aggregate demand (AD).
• Increases in AD and economic growth will
accelerate investment by businesses, while
decreases in AD and growth will decelerate it.
• This leads Keynesians to recommend demandmanagement fiscal policies.
Nondiscretionary Fiscal Policy
• Automatic stabilizers are changes in fiscal
policy that stimulate aggregate demand
when the economy goes into a recession
without policymakers having to take any
discretionary action.
• Automatic stabilizers include the tax
system and some forms of government
spending.
Discretionary Fiscal Policy
• Taxes: When policymakers change taxes,
the effect on aggregate demand is
indirect—through the spending decisions
of firms or households.
• Government Spending: When the
government alters its own purchases of
goods or services, it shifts the aggregatedemand curve directly.
Discretionary Fiscal Policy
Two Situations:
• Recession: Expansionary Fiscal Policy
* Demand-pull Inflation: Contractionary
Fiscal Policy
Recessionary Gap
Expansionary Fiscal Policy
Options
1. Increase Government Spending
2. Reduce Taxes
3. Some Combination of the Two
Inflationary Gap
Contractionary Fiscal Policy
Options
1. Decrease Government Spending
2. Increase Taxes
3. Some Combination of the Two
Neoclassical (Monetarist) View
• Milton Friedman and Anna Schwarz argued that
the Great Depression began as a result of
monetary contraction.
• Therefore, the decrease in investment was not
the result of a decrease in AD but a decrease in
the money supply.
• Thus, monetarists criticize demandmanagement as “the wrong cure for the wrong
disease.”
Theory of Malinvestment (Classical)
• Classical (Austrian school) economists such as
Friedrich Von Hayek held that the Great
Depression was caused by malinvestment.
• In this view, the Great Depression was the
result of a credit boom in the 1920’s that
caused businesses to invest in projects that
appeared profitable at the artificially low interest
rates engineered by the central bank (the Fed).
Theory of Malinvestment (Classical)
• The remedy for an economic contraction,
according to this view, is to avoid the
downturn altogether.
• Since government intervention caused the
problem, no government intervention,
before or after 1929, would have
prevented it.