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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.