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Chapter 35 Additional Insights - Chapter 35 The Modern...

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Chapter 35 The Modern Fiscal Policy Dilemma Additional Insights Classical economist followed the theory of ‘sound finance’. The theory of ‘sound finance’ states that the only time a county should run a deficit (incur debts) is in defense of the nation, i.e. wartime. Sound finance creates a pro-cyclical fiscal policy. When economic activity declines (contractionary phase of the business cycle) tax revenues will fall and in response the government will cut back on spending (the AD curve will shift to the left). As government spending on goods and services decline (G); total output (Y) will decline via the multiplier. The new equilibrium will be below potential GDP with an increase in the number of persons who are without gainful employment. This raises several questions. Will (can) the private sector fill the output gap opened up by the reduction in (G) or will the economy remain below potential for an extended period of time? A second and equally important question is whether or not a Classical economist would even ask this question.
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