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Fiscal Policy July 6, 2009

Posted by petrarcanomics in Role of Government.
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Expansionary Fiscal Policies

Expansionary fiscal policies include government spending increases and/or decreases in taxes. Effective expansionary fiscal policies will cause a rightward shift in aggregate demand.

Contractionary Fiscal Policies

Contractionary fiscal policies include government spending decreases and/or increases in taxes that would decrease the level of overall spending and cause a leftward shift in aggregate demand.

John Maynard Keynes

Keynes sought out to solve the conundrum of the rapidly declining spending of the great depression era. Keynes’ solution was that government should literally deficit spend during such periods to make up for the lack of spending occurring in the private sector. He said that such spending during recessionary periods would not be inflationary because the short-run aggregate supply curve is horizontal in such times. Therefore an increase in aggregate demand would have little or no effect on price level.

Classicalist Viewpoint

Classicalist economists such as Jean Baptiste Say saw the short-run aggregate supply (SRAS) curve as closer to vertical. He believed that deficit spending would be largely inflationary. Say believed that supply would create its own demand because more workers would be employed to create that supply. Classicalists also believe that corrective actions by the government are largely detrimental to the long-term health of the economy. They also believe that automatic stabilizers in the economy such as increased  unemployment insurance payments as more workers are unemployed will help stabilize the economy.

Historical Economic Periods

The 1970s stagflationary period of rising unemployment and rising prices are a great example of what can be explained using the aggregate demand / aggregate supply model. For example, as oil prices tripled in the 1970s, short-run aggregate supply shifted to the left because oil was an essential input resource cost that rippled throughout the production of many goods and services in the economy. This SRAS shift to the left naturally increased price levels while at the same time decreasing output or real GDP in the economy. So the understanding of the aggregate demand / aggregate supply model is essential to explaining many historical economic periods.

See these Reffonomics pages for more info:

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