Fiscal Policy

Economic Thought

In this section we take a brief look at the evolution of economic thought and follow with an analysis of Keynesian economics.

Classical Laissez-faire Economics

The earliest organized school of economic thought is known as Classical. The father of this school is Adam Smith. Smith used the concept of the invisible hand to describe the role of the market in the allocation of resources. In the market, the interaction of demand and supply determines how much of a good will be produced and the price that is charged for that good. Absent any explicit guidance mechanism, the invisible hand guides participants in the market towards an outcome that efficiently allocates resources to the production of goods that society desires.

Other important classical economists include David Ricardo who introduced and developed the concepts of comparative advantage and the benefits of an open economy that participates in international trade. J.B. Says presented what is today known as Say's Law: supply creates its own demand. Say's law captures the essence of the classical school of thought. The statement that supply creates its own demand implies that by producing goods and services, firms create the jobs and incomes capable of buying those goods and services.

With economic foundations based on the role of markets, a theory generally free of outside intervention, and emphasizing the role of production in determining income and economic output, the classical school of thought has several important implications:

An Early Theory of Value

One of the most important questions early classical economists attempted to answer was how the value or price of a good is determined. Smith described how the interaction of supply and demand in the market determined a good's price. Smith needed to go further and explain why two goods with identical demands would have different prices. According to Smith, the prices of goods are determined by what it costs to produce them. Since the majority input used in production during the eighteenth century was labor, Smith developed a labor-based theory of prices. The price of a good reflects the amount of labor used in its creation. One good's price is higher than another's because of the extra labor used in its production.

However, in Smith's model the price of a good is independent of the amount produced, resulting in a horizontal supply curve. From this base, Ricardo introduced the idea of diminishing returns in the factors of production. Diminishing returns in labor implies that as additional workers are used in production, the incremental output from each added worker is less than the output gained from hiring the previous worker. The quality of workers does not contribute to diminishing returns; rather, factors outside the individual worker's control yield this result.

Ricardo used the example of agriculture. Initially the best, most productive lands were farmed. But as the population grew, marginal lands were harvested, bringing down the yield per acre. As a result, additional labor would be needed to produce an extra bushel of grain. Due to diminishing returns, the price of a good increases as the quantity produced increases, resulting in an upward-sloping supply curve.

Taking Ricardo's law of diminishing returns one step further was Thomas Malthus. Malthus considered the increase in population that was occurring over time in comparison to the fixed supply of land. With diminishing returns prominent as increasing amounts of land are required to feed the growing population, there would eventually be a shortage of food. Agricultural output per acre would expand at a diminishing rate as increasingly marginal land was used to feed more and more people. Eventually, Malthus predicted, famine and starvation would result.

So far, Malthus's predictions have not been realized on a global scale. Although starvation does occur, it is a result of local conditions. At the present time, world food production is sufficient to accommodate the world's people. Population growth accompanied by famine has not been a problem due to the technological changes that have made workers and land more productive. The use of increasing amounts of fertilizers and better capital has easily offset any diminishing returns due to the use of lower quality land. In many cases, prices of goods have fallen in the long-run as output has expanded.

To complete the theory of price determination, Alfred Marshall looked at the margin. Along the producer's supply curve, higher prices are required to increase the quantity supplied. The supply curve shows the increasing cost of making an additional (marginal) unit of the good; its upward slope reflects increasing marginal costs. While along the consumer's demand curve, lower prices are required to induce the consumer to buy that additional unit of the good produced. The downward slope of the demand curve reflects decreasing marginal usefulness. By combining demand and supply, Marshall showed how the two curves simultaneously determined price.

A Great Depression

A course in macroeconomics teaches the student the role of the government in dealing with business cycles. If economic thought had stopped with the classical economists, there would be no need for a course in macroeconomics. As mentioned, the classical economists believed that there was only a minimal role for the government in the economy. The natural economic condition was at full employment, and the government should not interfere with the efficient operation of markets which yield that outcome. Economic recessions, even depressions, were temporary in nature. Left alone, the economy would return to a level consistent with potential output.

And so the world of economic thought went until the Great Depression of the 1930s. For many industrialized nations, output plummeted and unemployment rates soared during the 1930s. In the United States, unemployment reached 25% and output dropped by over 30% from the level reached in 1929. The classical argument that falling prices and interest rates would restore economic prosperity never occurred (1). The economy remained stuck. With high unemployment, there was not enough consumer income to stimulate consumption and aggregate demand. With falling demand for output, business investment sank. High tariffs prevented an export-driven growth stimulus (2).

(1) Flexible and falling prices, wages, and interest rates could offset an economic slowdown in several ways. In a business downturn, a decrease in labor demand and layoffs lead to a decrease in wages. Lower wages reduce the relative price of employing labor relative to capital and create an offsetting increase in the demand for labor. If prices fall further than wages, then purchasing power increases. Furthermore, with falling prices, the value of wealth holdings also increases - both effects contribute to increased consumption, offsetting the initial decrease in aggregate demand that caused the economic downturn in the first place.

Lower interest rates improve the return on investment, resulting in an increase in business investment and an increase in aggregate demand.

(2) Several important factors combined to make the 1930s a decade of extreme economic depression.

Stunned by the magnitude and duration of the Depression, classical economists went into a funk. The traditional classical solution to the business cycle - allow prices, wages, and interest rates to adjust and wait it out, was not working. Wages, prices, and interest rates did fall, and yet output continued to sink further, while the unemployment rate soared well beyond any level justified as voluntary. The traditional catalysts for economic growth, consumption, investment, and international trade were in a catatonic state. Massive unemployment, coupled with a devastating loss in wealth, left consumption moribund. Businesses had no reason to invest in expanding productive capacity when demand for their goods and services had fallen off a cliff. Finally, the Smoot-Hawley tariffs led to a substantial contraction in foreign trade activity and potential export markets in countries that were doing better economically.

This left only one sector of aggregate demand with the potential to resurrect the economy: government spending. John Keynes pointed out the obvious - when traditional methods of economic stimulus fail, use the government as a last resort and use it forcefully.

Keynes was an economist educated by classical scholars. He took their theory a step further and exposed the shortcoming, establishing his own ideas on the classical foundation and leaving his own school of economic thought and policy. Keynes pointed out several problems with classical theory. An important point was that wages tended to be sticky and would not fall as much as prices during economic downturns. The result is an increase in real wages (w/p) and a decrease in the demand for labor as the real cost of labor inputs increases. Keynes also developed the idea that during periods of economic weakness investment tends to be relatively interest-inelastic, or investment is relatively unresponsive to changes in the interest rate. Thus, a decrease in the rate of interest will have little or no stimulative impact on the investment component of aggregate demand.

The Basics of Fiscal Policy

In this section we will cover the basics of fiscal policy. Fiscal policy is carried out by the executive and legislative branches of government that make policy regarding government spending programs and taxation. Unlike monetary policy that can be changed by the Chairman of the Federal Reserve immediately, fiscal policy is part of the process of making laws and government budgeting, although emergency expenditures can be undertaken.

It is important to note that in the United States, discretionary fiscal policy has only a minor role when dealing with the economy. This is not to say that the government sector is unimportant, but current debates regarding fiscal policy are not orientated towards counteracting the business cycle. This is a result of the tremendous federal budget deficits present during the 1980s and 1990s, and the rapid accumulation in the national debt. The White House and Congress have made deficit reduction the primary focus of fiscal policy and let the Federal Reserve take the economic reigns.

To begin, let us take our basic equation for GDP, that sums up consumption, investment, government spending and net exports:

GDP = C + I + G + NX

and modify it to become:

AD = GDP = C(Y - T) + I(r) + G + NX


It is critical to note that  I(r) in the above equation describes Investment (I) is a function of the interest rate (r). As r increases, I will decrease and as r decreases, investment will rise. What  I(r) is not describing is I times r ( I * r).

Using this equation for GDP we can break fiscal policy into two parts:

Discretionary fiscal policy that is used to counteract the business cycle can be split into two parts:

Expansionary fiscal policy would be used to speed up the rate of GDP growth or during a recession when GDP growth is negative. A tax cut and/or an increase in government spending would be implemented to stimulate economic growth and lower unemployment rates. These policies will lead to higher federal budget deficits.

A restrictive fiscal policy involves raising taxes or cutting government spending in an attempt to dampen GDP (aggregate demand) growth and lower inflationary pressures.

Fiscal policy impacts the growth rate of aggregate demand, given a constant growth in aggregate supply. Earlier in this course we studied how changes in aggregate demand in relation to aggregate supply can result in variations in GDP growth and possibly in the rate of inflation.




Our first graph shows the impact of a restrictive fiscal policy that reduces the growth rate of aggregate demand in proportion to aggregate supply. Inflationary pressures are dampened, but higher unemployment rates will result.

In contrast to a restrictive fiscal policy that raises taxes and/or slashes government expenditures is an expansionary fiscal policy that is implemented with tax cuts and higher levels of government spending.




As we can see graphically, at AD1, there is a great deal of unused capacity present in the economy. The aggregate demand curve intersects the aggregate supply curve well to the left of the full employment level of output. Undesirably high unemployment rates are the likely consequence.

An expansionary fiscal policy will boost aggregate demand in relation to the aggregate supply curve as shown by the shift out to AD1. There is a greater level of output and increased demand for labor.