Fiscal policy aims to use government spending and taxes to move the economy towards full employment and price stability by adjusting aggregate demand. The document discusses the concept of potential output, which is the maximum sustainable output of an economy given available resources and technology. It states that when the economy is at potential output, there is full employment and price stability. The document also explains that fiscal policy attempts to boost aggregate demand to increase real GDP when it is below potential output, as during the Great Recession, and discusses debates around fiscal policy before and during the Great Depression.

1. THE EVOLUTION OF
FISCAL POLICY

2. Fiscal Policy and Potential
Output
Fiscal 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.
If unemployment is high, as it was because of the
Great Recession of 2008-2009, fiscal policy tries
to increase
Aggregate demand as a way of boosting output
and

3. Potential Output
Fiscal policy aims to move the
economy
To its potential output level.
Potential output is the
economy’s maximum
sustainable output in the long
run, given the supply of
resources , the state of
technology, and the rules of
the game that nurture
production and exchange.

4. Output Below Potential
 If the aggregate demand curve and aggregate
supply curve intersect in the pink shaded area
of Figure 4.7, then output is less than the
economy’s potential .

5. Output Exceeding Potential
If the aggregate demand curve and aggregate
supply curve intersect in the blue-shaded area of
Figure 4.7, then output exceeds the economy’s .

6. FIGURE.4.7
Fiscal Policy and Potential Output
Potential Output is the economy’s maximum
sustainable output in the long run. The pink-shaded
area indicates real GDP below the economy’s
potential . The blue-shaded area indicates real GDP
exceeding the economy’s potential. When the
economy reaches potential output ,there is full
employment and price stability.

7. POTENTIAL OUTPUT
Price
level

8. How can Output Exceed the
Economy’s Potential ?
 You probably have no problem understanding
that output may fall short if its potential. But
how can output exceeds its potential ?
Remember , potential output does not mean
zero unemployment about 5-6 percent. Even
an economy producing its potential output
has some unemployed labor and some
unused production capacity.

9. The U.S. Fiscal Policy and the Great
Depression
 In the United States , before the Great
depression , most policy makers believed that
an economy producing less than is potential in
the short run would move to its potential in
the long run without help from the federal
government .

10. Views of Classical Economists
 Before the 1930s, fiscal policy was seldom
used to influence the overall performance of
the economy. Prior to the Great depression ,
public policy was shaped by the views of
classical economists

11. The Great Depression and
Keynes
 Classical economists acknowledge that market
economies could produce less than potential
in the short run . The prolonged depression of
the 1930s however, strained belief in the
economy’s ability to correct itself. The Great
depression was marked by unemployment
reaching 25 percent and much unused plant
capacity.