Section 2 Fiscal Policy Options

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Objectives

After studying this section you will be able to:

1. Compare and contrast classical economics and Keynesian economics.
2. Explain the basic principles of supply-side economics.
3. Understand the role that fiscal policy has played in American history.

Section Focus

Fiscal policy is the use of government spending and taxes to work toward low unemployment, low inflation, and steady economic growth. Keynesian economic theories and supply-side economic theories suggest two very different ways for government to encourage growth.

Key Terms

• classical economics
• productive capacity
• demand-side economics
• Keynesian economics
• multiplier effect
• automatic stabilizer
• supply-side economics
• Council of Economic Advisers (CEA)

For thousands of years, governments have collected taxes and spent money. Until the 1930s, however, most economists believed that a government should keep its role in the economy small. These economists belonged to a school of thought called classical economics.

Classical Economics

Throughout this book, you have read about the workings of a free market economy. In a free market, people act in their own self-interest, causing prices to rise or fall so that supply and demand will always return to equilibrium. This idea that free markets regulate themselves is at the heart of a school of thought known as classical economics. Adam Smith, David Ricardo, and Thomas Malthus are all considered classical economists. For more than a century, classical economics dominated economic theory and government policies.

The Great Depression that began in 1929 challenged this thinking. Prices fell over several years, so demand should have increased enough to stimulate production as consumers took advantage of low prices. Instead, demand also fell as people lost their jobs and bank failures wiped out their savings. According to classical economics, the market should have reached equilibrium, with full employment. But it didn't, and millions suffered from unemployment and other hardships. Many people were too poor to buy enough food for their families, while farmers lost their farms because corn was selling for seven cents a bushel, beef for two and a half cents a pound, and apples were five for a penny.

The economic hardships brought about by the Great Depression challenged the ideas of classical economics.

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