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Chapter 16 - The fiscal policy dilemma. After reading this chapter, you should be able to: Summarize the Classical view of sound finance, summarize the Keynesian view of functional finance, list six assumptions of the AS/AD model that lead to potential problems with the use of fiscal policy. | An economist’s lag may be a politician’s catastrophe. ―George Schultz The Fiscal Policy Dilemma Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Goals Summarize the Classical view of sound finance Summarize the Keynesian view of functional finance List six assumptions of the AS/AD model that lead to potential problems with the use of fiscal policy Explain how automatic stabilizers work 2 The Fiscal Policy Dilemma The fiscal policy dilemma is what to do in periods of structural stagnation when both deficits and a balanced budget are called for When an economy falls into a structural stagnation, the effectiveness of expansionary demand-side policy is limited A government that cannot easily finance its debt will either go bankrupt or have to resort to inflationary finance, with the central bank financing the government by printing money 3 Classical Economics and Sound Finance Sound finance was a view of fiscal policy that the government . | An economist’s lag may be a politician’s catastrophe. ―George Schultz The Fiscal Policy Dilemma Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Goals Summarize the Classical view of sound finance Summarize the Keynesian view of functional finance List six assumptions of the AS/AD model that lead to potential problems with the use of fiscal policy Explain how automatic stabilizers work 2 The Fiscal Policy Dilemma The fiscal policy dilemma is what to do in periods of structural stagnation when both deficits and a balanced budget are called for When an economy falls into a structural stagnation, the effectiveness of expansionary demand-side policy is limited A government that cannot easily finance its debt will either go bankrupt or have to resort to inflationary finance, with the central bank financing the government by printing money 3 Classical Economics and Sound Finance Sound finance was a view of fiscal policy that the government budget should always be balanced except in wartime This view was based on a combination of political and economic grounds, but primarily on political grounds Ricardian equivalence theorem is that deficits do not affect the level of output because people increase savings to pay future taxes to repay the deficit Most economists felt that, in practice, deficits could affect output and that it mattered a lot 4 The Sound-Finance Precept Given the collapse of economic expectations in the 1930s, many economists of the time favored giving up the principle of sound finance, at least temporarily, and using government spending to stimulate the economy If the economy is in a small recession, do nothing If the economy is in a depression, use deficit spending 5 Keynesian Economics and Functional Finance Functional finance held that governments should make spending and taxing decisions on the basis of their effect on the economy, not on the basis of some moralistic principle that budgets should be .
