Fiscal Policy within the IS-LM Framework

Shahdad Naghshpour

• Publisher: Business Expert Press
• Year: 2014
• ISBN:
  9781606497234
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Undoubtedly, what happens to the economy affects the lives of the citizens of a country, and often the lives of people in other countries around the globe. In addition to natural disasters two things affect the economy more than anything else: monetary and fiscal policies. Fiscal policy and monetary policy represent forms of government intervention to influence market performance. Fiscal policy relates to government spending and revenue collection; monetary policy relates to the supply of money, which is controlled by factors such as reserve requirements and interest rates. If there were a universally accepted set of rules that prescribe appropriate actions to bring and sustain prosperity to the economy the study of economics would have been a positive science, as opposed to a collection of normative beliefs. The study of these policies is normative in nature because fiscal and monetary policies do not necessarily impact everyone equally or in the same way. In other words not everybody loses or gains equally as the result of fiscal and monetary policies. Nevertheless, there are non-normative economic theories that explain the expected outcome of specific fiscal or monetary policies.The economists that advocate for fiscal or monetary policies generally agree on the economic consequences produced by each policy when implemented. What differentiates the economists is the degree to which they believe in the effectiveness of the policy, their ability to know the extent of the need that it is intended to address, the proper amount of intervention required in order to effect the desired correction, and the length of the time it would take to see the consequence of the policy.This book covers fiscal policy. It is part of a projected two volume set covering fiscal and monetary policies. The two volumes will be written to be complimentary to but independent of each other.

Section I

Background and Fundamental Theories

Chapter 1

A Brief History of Fiscal Theory

It is seldom possible to pinpoint the birth of an idiom, or know exactly when a term was coined. However, in the case of macroeconomics we are able to do that. The term “macroeconomics” was coined by Klein in 1946, in an article titled “Macroeconomics and the Theory of Rational Behavior.”

Definition

Macroeconomics is the study of aggregated indicators, such as gross domestic product (GDP).

Definition

GDP is the value of final goods and services produced in a country in one year.

The conduct of governments in modern economies affects aggregate economic indicators. The influence of government on the economy is often deliberate, for example, when taxes are increased to reduce budget deficits. Sometimes the purpose of government action is not to influence the economy but rather for other causes, such as improving the welfare of orphans or supporting single mothers through social security payments. Regardless of the purpose of government action, GDP is still affected. Government intervention in the economy for the purpose of changing aggregate indicators falls into two distinct forms: fiscal policy and monetary policy.

Definition

Fiscal Policy refers to government intervention in the economy through manipulation of government revenues and disbursements, for the purpose of influencing the course of the economy.

Definition

Monetary Policy refers to government intervention in the economy through manipulation of supply of money, for the purpose of influencing the course of the economy.

Whether the government should intervene in the economy is a normative question. This book does not address the wisdom of government intervention in the economy; instead, it focuses on the effects of government interventions on the economy. More specifically, it focuses on the impact of taxes and expenditures on macroeconomic indicators.

The branch of economics that covers these subjects is called macroeconomics. The fact that the term was not devised until 1946 does not mean that the concept was not in use before this time. Macroeconomics is a formal way of addressing economic aggregates such as the price level, unemployment rate, national product, and the like. The coverage of macroeconomic topics for the first two centuries of modern economics was sparse, and it was usually based on microeconomic perspectives. In fact, addressing larger scale issues, such as inflation, full employment, aggregate output, and a possible role for government to use fiscal and monetary tools to influence them, did not exist until 1936, when John Maynard Keynes published The General Theory of Employment, Interest, and Money. Keynes’s work was timely because of the Great Depression of 1929. During the Great Depression the free market system was not able to correct itself and cause a return to the full employment.

Definition

An economic recession refers to an overall decline in an economy. In the United States a recession is declared when GDP declines for two consecutive quarters.

Definition

An economic depression is a severe case of a recession.

Most but not necessarily all economic activities decline during a recession. A prolonged decline in the economy is necessary to conclude that a recession exists, since short-term fluctuations in the economy are common.

The Great Depression was the most severe depression of the modern era. By most accounts, the Great Depression began in late summer of 1929 and became acute in October 1929, when the stock market in the United States crashed. The Depression spread to most industrialized countries, and its effects were still present as late as 1939. During the Great Depression, reductions in production, prices, and trade were substantial. Unemployment was high and widespread in industrialized countries. The economic decline during the Great Depression surpassed all recessions in the recorded history of the last several centuries.

What Is Fiscal Theory?

It seems logical to refer to the theories that provide economic justifications for fiscal policy as fiscal theory. However, the term is not commonly used. The concept of fiscal policy is closely related to the notion of aggregate product and income. The theories that are applicable to fiscal policy are covered in the domain of macroeconomics. The theoretical foundation of fiscal theory is covered under the subject of income determination. In its simplest form the theory is based on the fact that national income consists of the aggregate income of each sector of the economy. Similar entities are grouped together. Consumer expenditures are grouped together and represent consumption (C). The other groups represent investment (I), government expenditures (G), and foreign trade. Foreign trade consists of two components; imports (M) and exports (X). Customarily, net trade is utilized (X – M ). The sum of consumption, investment, ­government expenditures, and net trade constitutes aggregate expenditure. Since expendi­ture by one person is income for another person, aggregate expenditure is identical to aggregate income.

There is a subtle difference between GDP and gross national ­product (GNP). The former consists of all goods and services produced in a ­country, regardless of the nationality of the producer. The latter is the value of all goods and services produced by the citizens of a country, regardless of their location of residency. Until 1991, GNP was the primary measure of aggregate productivity in the United States. Using GDP instead of GNP accomplished two things. First, it provided a better measure of the productivity of the nation since it is based on the use of resources in the country. Second, it allowed a more accurate comparison of productivity of the United States with other countries, since GDP is more commonly used.

Early Fiscal Theories

By most accounts, Keynes originated the theory of income determination. There is little doubt that the inability to avoid the Great Depression, or at least slow it down, was essential in prompting economists to realize that a solution based on something other than monetary theory is necessary to soften the troughs and peaks of business cycles. Business cycles existed before that time period and were studied by Sismondi as early as 1819. However, Frisch often receives credit for starting macroeconomics, since he used the term “macrodynamic” in his study of economic cycles.1

The existence of business cycles was problematic for classical economists. According to Adam Smith, the invisible hand allocates resources to products that are demanded and away from products that are not. Under classical economics, disequilibrium is a temporary situation, during which the invisible hand is busy reallocating resources to their best use, in order to maximize the utilities of consumers and the profits of producers. An important point to remember is that the foundation of classical economics originated in microeconomics, since macroeconomics was not formally established for another 200 years. Under classical economics, disequilibrium is a temporary condition, and the likelihood that all econo...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication Page
• Abstract
• Contents
• List of Figures
• Acknowledgments
• Section I: Background and Fundamental Theories
• Section II: Interest Rate and Fiscal Theory
• Section III: Schools of Thought in Fiscal Theory
• Glossary
• Notes
• References
• Index
• Adpage
• Back Cover