John Maynard Keynes was a British economist in the early 20th century whose ideas had a major impact on modern economic theory and government fiscal policy. He advocated for interventionist government policies using fiscal and monetary measures to mitigate the adverse effects of economic downturns. Keynesians believe the government can use changes in spending and taxes to influence aggregate demand and achieve goals like high employment and price stability. However, fiscal policy does not operate in isolation and may be offset by factors like crowding out of private sector spending or individuals anticipating future tax changes.

1. Fiscal Policy and Keynesians

2. John Maynard Keynes
John Maynard Keynes, (June 5, 1883 –
April 21, 1946) was a British economist
whose ideas had a major impact on
modern economic and political theory as
well as on many governments' fiscal
policies.
He is particularly remembered for
advocating interventionist government
policy, by which the government would
use fiscal and monetary measures to aim
to mitigate the adverse effects of
economic recessions, depressions and
booms. Economists consider him one of
the main founders of modern theoretical
macroeconomics. His popular expression
"In the long run we are all dead" is still
quoted.

3. Discretionary Fiscal Policy
 Discretionary Fiscal Policy
 The discretionary changes in government
expenditures and/or taxes in order to
achieve certain national economic goals is
the realm of fiscal policy.
 High employment (low unemployment)
 Price stability
 Economic growth
 Improvement of international payments
balance

4. Discretionary Fiscal Policy
(cont'd)
 Fiscal Policy
 The discretionary changing of government expenditures or
taxes to achieve national economic goals, such as high
employment with price stability

5. Discretionary Fiscal Policy
(cont'd)
 An increase in government spending will stimulate
economic activity
 Changes in government spending
 Military spending
 Education spending
 Budgets for government agencies

6. Figure 13-1 Expansionary and
Contractionary Fiscal Policy:
Changes in Government Spending,
Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand

7. Figure 13-1 Expansionary and
Contractionary Fiscal Policy:
Changes in Government Spending,
Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand

8. Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS

9. Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level

10. Discretionary Fiscal Policy
(cont'd)
 Change in taxes
 A rise in taxes causes a reduction in aggregate demand
because it can reduce consumption spending, investment
expenditures, and net exports.

11. Possible Offsets to Fiscal Policy
 Fiscal policy does not operate in a vacuum and important questions must
be answered.
 How are expenditures financed and
by whom?
 If taxes are increased what does government do with the taxes?
 What will happen if individuals worry about increases in future taxes?

12. Possible Offsets
to Fiscal Policy (cont'd)
 Crowding-Out Effect
 The tendency of expansionary fiscal policy to cause a
decrease in planned investment or planned consumption in
the private sector; this decrease normally results from the
rise of interest rates.

13. The Crowding-Out Effect,
Step by Step

14. The Crowding-Out Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap

15. Possible Offsets to Fiscal Policy (cont'd)
 Planning for the future:
the Ricardian equivalence theorem
 Ricardian Equivalence Theorem
 The proposition that an increase in the government budget deficit has no effect on
aggregate demand
 The reason for the offset
 People anticipate that a larger deficit today will mean higher taxes in the future and
adjust their spending accordingly.

16. Possible Offsets
to Fiscal Policy (cont'd)
 Direct Expenditure Offsets
 Actions on the part of the private sector in spending
income that offset government fiscal policy actions
 Any increase in government spending
in an area that competes with the
private sector will have some direct expenditure offset.

17. Possible Offsets
to Fiscal Policy (cont'd)
 The supply-side effects of changes
in taxes
 Expansionary fiscal policy could involve reducing marginal
tax rates.
 Advocates argue this increases productivity since individuals
will work harder and longer, save more, and invest more.
 The increased productivity will lead to more economic
growth.

18. Possible Offsets
to Fiscal Policy (cont'd)
 Supply-Side Economics
 The suggestion that creating incentives for individuals and
firms to increase productivity will cause the aggregate
supply curve to shift outward

19. Laffer Curve
Khaldun-Laffer curve is a representation of the relationship
between possible rates of taxation and the resulting levels of
government revenue.
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together

20. Discretionary Fiscal Policy in Practice:
Coping with Time Lags
 Recognition Time Lag
 The time required to gather information about the current state of the economy
 Action Time Lag
 The time required between recognizing an economic problem and putting policy into
effect
 Effect Time Lag
 The time it takes for a fiscal policy to affect
the economy

21. Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
 Fiscal policy time lags are long and a
policy designed to correct a recession
may not produce results until the
economy is experiencing inflation.
 Fiscal policy time lags are variable in
length (1–3 years), and the timing of the
desired effect cannot be predicted.
 Because fiscal policy time lags tend to be
variable, policymakers have a difficult
time fine-tuning the economy.

22. Automatic Stabilizers
 Automatic or Built-In Stabilizers
 Changes in government spending and taxation that occur
automatically without deliberate action of Congress
 The tax system
 Unemployment compensation
 Welfare spending

23. Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its full-employment
output level

24. What Do We Really Know
About Fiscal Policy?
 Fiscal policy during normal times
 Congress ends up doing too little too late to help in a
minor recession.
 Fiscal policy that generates repeated
tax changes (as has happened)
creates uncertainty.

25. What Do We Really Know
About Fiscal Policy? (cont'd)
 Fiscal policy during abnormal times
 Fiscal policy can be effective
 The Great Depression—fiscal policy may be able to stimulate
aggregate demand.
 Wartime—during World War II real GDP increased dramatically.

26. What Do We Really Know
About Fiscal Policy? (cont'd)
 The “soothing” effect of Keynesian fiscal policy
 Should we encounter a severe downturn, fiscal policy is
available.
 Knowing this may reassure consumers
and investors.
 Stable expectations encourage a smoothing of investment
spending.