CHAPTER 17

Stabilizing the National Economy

Section 2: The Fiscal Policy Approach to Stabilization Fiscal Policy- Federal Government’s use

of taxation and spending policies to affect overall business activity

The Circular Flow of Income

Income flows from businesses to households as wages, rent, interest, and profits. Income flows from households to businesses as payments for consumer goods and services

Not all income follows the circular flow. Some is removed from the cycle through taxes and savings (Leakage). Business investment and government spending offset leakages (Injections).

Govt

borro

ws

The Circular Flow of Income

Income

Savings

Loans for

investment

Purchases Purchase

s

Taxes Taxes

Wages, Transfer Payments, Interest

Two Major Schools of Thought on Fiscal Policy Demand-Side (Keynesian Economics) Supply-side Economics (Jean-Baptiste

Say; also referred to as Reaganomics)

Keynesian Economics

John Maynard Keynes developed fiscal policy theories during the Great Depression

Said that forces of aggregate supply and demand acted too slowly during a serious recession government needed to inject $ into economy into stimulate aggregate demand

His policies are known as Demand-Side Economics

Democrats tend to follow Demand-Side Economics

Illustration of Demand-Side Economics Govt. job programs to reduce unemployment

and stimulate the economy Govt. hires the unemployed to work on public-

works projects (roads, bridges, power plants, etc.) borrows money to pay them workers go out and spend money demand for goods increases businesses hire back their laid off workers aggregate demand expands enter expansion period Govt. pays off its loan by charging a fee to use the public works (ex- tolls) that the workers completed

Supply-Side Economics

Govt. cuts federal taxes, especially for big businesses give businesses tax credits on investment allowing them to purchase new equipment and hire more workers more workers means more spending new businesses open to meet the demand economic expansion

Examples of Supply-Side Economics Reagonomics-

Trickle-Down Theory of the 1980’s

President Bush’s Jobs and Growth Tax Act of 2003

Problems with Fiscal Policy

Politicians overuse them they are only supposed to be used to get us out of a recession

Republicans get elected on promises of tax cuts, so they hesitate to raise taxes when the economy expands too quickly

Democrats get elected on promises of increased spending on jobs programs and social welfare programs, so they hesitate to decrease the funding when the economy is expanding too quickly

Section 3: Monetarism and the Economy

Monetarism is the theory that deals with the relationship between the amount of money the Fed places in circulation and the level of activity in the economy

Milton Friedman is a leading supporter of monetarism

Monetarists argue that the Fed should increase the money supply at a set rate every year.

Government Policy according to Monetarists

Monetarists oppose fiscal policy because they believe that the government does more harm than good when they try to manipulate the economy

Against budget deficits and deficit spending to stimulate the economy govt. should balance their budget, erase all debts, and stop competing with businesses to borrow $ from banks

Support the monetary rule, allowing the money supply to grow steadily at a rate of 3-5% a year controlled expansion would avoid rapid inflation and high unemployment

The Fed used monetary policy in the 1980’s and it worked, but then 9/11 happened an everything became unpredictable

Monetarist’s Criticism of Fiscal Policy

No one single government body is responsible for fiscal policy

President, OMB, Sec’y of Treasury, and Council of Economic Advisors recommend changes in fiscal policy Congress, w/ the aid of many committees enacts fiscal policy politics and loyalties get in the way changes are made to suit special interests recommended policy and actual policy differ greatly

Even if the recommendations are followed, there are time lags between the start of the budget process and when the fiscal policy actually goes into effect too slow to stop the economic crisis