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CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy
Identify the economy’s potential output level.
Distinguish between fiscal policy before and after the Great Depression.
Objectives
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy
potential outputnatural rate of unemploymentclassical economistsannually balanced budgetmultiplier effect
Key Terms
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE3
Fiscal Policy and Potential OutputFiscal policy aims to use government
taxing and spending to move the economy toward full employment with price stability.The focus is mainly on shifts of the
aggregate demand curve.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE4
Potential OutputPotential output is the economy’s
maximum sustainable output in the long run.Potential output also is referred to as the
full-employment output.The natural rate of unemployment is the
unemployment rate when the economy is producing its potential level of output.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE5
Fiscal Policy and Potential Output The pink-shaded
area indicates real GDP below the economy’s potential.
The blue-shaded area indicates real GDP exceeding the economy’s potential.
Figure 15.1
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE6
Output Below PotentialThe economy is not producing as much as
it can. Unemployment exceeds its natural rate. The amount by which short-run output falls
short of the economy’s potential output is called a contractionary gap.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE7
Output Exceeding PotentialUnemployment is below its natural rate.The amount by which actual output in the
short run exceeds the economy’s potential output is called the expansionary gap.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE8How Can Output Exceed the
Economy’s Potential?Potential output means not zero
unemployment, but the natural rate of unemployment. Even in an economy producing its
potential output, there is still some unemployed labor and some unused production capacity.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE9Discretionary Fiscal Policy
to Close a Contractionary GapThe aggregate demand
curve AD and the aggregate supply curve AS intersect at point e.
Output of $11.5 trillion falls short of the economy’s potential of $12.0 trillion.
The result is a contractionary gap of $0.5 trillion.
Figure 15.2
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE10Discretionary Fiscal Policy
to Close a Contractionary Gap
Figure 15.2
(continued)
This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount.
An increase in government spending, a decrease in taxes, or some combination of the two could shift aggregate demand to AD*, moving the economy to its potential level of output at e*.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE11
The Rise of Fiscal PolicyBefore the Great Depression, most policy
makers believed that an economy producing less than its potential in the short run would move to its potential in the long run without help from the federal government.They thought the government should just
balance its budget and forget about trying to stabilize the economy in the short run.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE12
The Rise of Fiscal PolicyBefore the Great Depression, the federal
government played a relatively minor role in the economy.Federal spending as a percent of GDP3 percent at the onset of the Great
Depression 20 percent today
(continued)
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15.1 The Evolution of Fiscal Policy SLIDE13
View of Classical Economists Classical economists—A group of laissez-faire
economists, who believed that economic downturns corrected themselves in the long run through natural market forces
Annually balanced budget—Matching annual spending with annual revenue, except during war years; approach to the federal budget prior to the Great Depression
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE14
The Great Depression and KeynesKeynesian theory and policy were
developed to address the problem of unemployment during the Great Depression.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE15
The Multiplier Effect Keynes also argued that any change in taxing or
government spending had a magnified effect on aggregate demand.
Each round of income and spending increases aggregate spending a little more.
The multiplier effect of fiscal policy says that any change in fiscal policy affects aggregate demand by more than the original change in spending or taxing.
CONTEMPORARY ECONOMICS © Thomson South-Western
15.1 The Evolution of Fiscal Policy SLIDE16
The Rise of Fiscal PolicyThree developments in the years following
the Great Depression supported the use of fiscal policy in the United States.The influence of Keynes’s General TheoryThe powerful impact World War II had on
output and employmentThe passage of the Employment Act of 1946
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15.2 Fiscal Policy Reconsidered
Identify the two tools of fiscal policy.Evaluate discretionary fiscal policy in light
of the time lags involved.
Objectives
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered
discretionary fiscal policyautomatic stabilizers recognition lagdecision-making lag implementation lageffectiveness lag
Key Terms
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered SLIDE3
Fiscal Policy ToolsThe tools of fiscal policy sort into two
broad categories: Discretionary fiscal policyAutomatic stabilizers
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered SLIDE4
Discretionary Fiscal PolicyDiscretionary fiscal policy—legislative
changes in government spending or taxing to promote macroeconomic goals
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered SLIDE5
Automatic StabilizersAutomatic stabilizers—government
spending and taxing programs that year after year automatically reduce fluctuations in disposable income, and thus in consumption, over the business cycle
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered SLIDE6Problems with
Discretionary Fiscal PolicyStagflationCalculating the natural rate of
unemployment
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15.2 Fiscal Policy Reconsidered SLIDE7
The Problem of Lags Recognition lag—the time it takes to identify a
problem and determine how serious it is Decision-making lag—the time needed to
decide what to do once the problem has been identified
Implementation lag—the time needed to execute a change in policy
Effectiveness lag—the time needed for changes in policy to affect the economy
CONTEMPORARY ECONOMICS © Thomson South-Western
15.2 Fiscal Policy Reconsidered SLIDE8
Fiscal Policy and Aggregate SupplyFiscal policy can affect aggregate supply,
although often that effect is unintentional.Both automatic stabilizers and
discretionary fiscal policies may affect individual incentives to work, spend, save, and invest.