Fiscal Policy
In the previous chapter, we examined concepts of aggregate supply and demand, consumption, and investment. We took
a brief look at government expenditures and the influence they have on consumption as well as aggregate supply and
demand. In this chapter, we examine more closely the role of the government in a market system, what it can and cannot
do, and the incentives it provides for firms and households.
There are two basic types of fiscal policy: discretionary and nondiscretionary fiscal policies. Discretionaryfiscal policy is
“active” government involvement in the economy. Tax changes and changes in government spending are both considered
discretionary fiscal policy. Nondiscretionaryfiscal policy is when the government decides to take a “nonactive” role in
the economy.
Classical Economics
Classical economicsis based on the premise that supply creates its own demand. According to classicalists, the forces
of supply and demand (self-interest) are the factors that aid the economy in times of market failures. French economist
J. B. Say was a major force in creating this theory. Classicalists believe that the act of producing goods generates in-
come equal to the value of the goods being produced. The production of any output automatically provides the income
needed to buy that output. The only problem with this is that individuals do not spend all of their income on goods and
services. Savings is one area Classicalists do not consider; prices and wages are sticky and do not quickly respond to
short-run fluctuations.
Keynesian Economics
During the 1930s, British economist John Maynard Keynes developed a new theory on the role of government in a mar-
ket system. He recommended active government involvement in times of economic turmoil. The Classical view that
government should adopt a laissez faire attitude toward the economy was no longer working in the case of the Great
Depression. The government could no longer afford to let the economy repair itself. Keynes developed the expenditures
model, the multiplier, and the propensity to consume. Keynes’ basic premise for governmental influence is that short-run
instability is caused by a lack of spending. It is the government’s responsibility to stimulate demand through spending.
Expansionary Fiscal Policy
As you’ll recall, in chapter 3 we discussed the business cycle and its four phases. Each phase in the business cycle
revealed the state of the economy. The federal government can implement what is called expansionary fiscal policy,
decreasing taxes and or increasing government spending, during a period of contraction. The aim of expansionary
fiscal policy is to stimulate the economy and steer it in the direction of growth.