Chapter 35 Notes - [ChapterThirtyFive LearningObjectives...

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[Chapter Thirty Five] The Modern Fiscal Policy Dilemma Learning Objectives After reading the material in this chapter, you will be able to do the following: 1. Explain the logic of the Ricardian equivalence theorem. 2. Distinguish sound finance from functional finance. 3. List six assumptions of the AS / AD model that lead to potential problems with the use of fiscal policy. 4. Explain how automatic stabilizers work. Chapter Outline The Modern Fiscal Policy Dilemma The modern fiscal policy dilemma is that when faced with the economy falling into a depression, governments need to run large deficits, but they can only do that for limited periods without undermining their long- run financial integrity. Classical Economics and Sound Finance Sound Finance: “A view of fiscal policy that the government budget should always be balanced except in wartime.” Before 1930s, this was the prevailing view. Ricardian Equivalence Theorem: Deficits Don’t Matter David Ricardo pointed out that, in a purely theoretical sense, government spending financed by selling bonds was no different from government spending financed by taxes, because if the government ran deficits, it would have to raise taxes in the future both to pay the interest on the bonds and to repay the bonds. Ricardian Equivalence Theorem: “Theoretical proposition that deficits do not affect the level of output in the economy because individuals increase their savings to account for expected future tax payments to repay the deficit.”
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Most economists felt that, in practice, deficits could affect output and that it mattered a lot, politically, whether the government financed its spending by bonds or by taxes; they argued that a policy of sound finance forced government to face the costs of a spending decision. Through the 1930s, fiscal policy was not part of the economist’s lexicon. The Sound-Finance Precept In the 1920s and 1930s, world economies fell into a sustained depression; major economists of the time started questioning the sound- finance principle for the short run. Many economists favored using government spending to stimulate the economy through government public works programs such as the Federal Emergency Relief Program and the Works Progress Administration. Their arguments for deficit spending were based on simple commonsense reasoning. They felt that if the government spent more than it collected in taxes, the economy would be jump-started, income would increase, spending would increase, etc. Policy-making economists of the time generally felt that expansionary fiscal policy could be of some use in pulling an economy out of a severe recession, but such deficit financing was a last resort that was inappropriate for small or moderate recessions. Keynesian Economics and Functional Finance
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Chapter 35 Notes - [ChapterThirtyFive LearningObjectives...

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