Question

Explain the difference between expansionary fiscal policy in the RBC and Keynesian models.

Answer 1

Classical economics emphasises the fact that free markets lead to an efficient outcome and are self-regulating. In macroeconomics, classical economics assumes the long run aggregate supply curve is inelastic; therefore any deviation from full employment will only be temporary.
The Classical model stresses the importance of limiting government intervention and striving to keep markets free of potential barriers to their efficient operation.
Keynesians argue that the economy can be below full capacity for a considerable time due to imperfect markets. Keynesians place a greater role for expansionary fiscal policy (government intervention) to overcome recession.The Keynesian view of long-run aggregate supply is different. They argue that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons.Wages are sticky downwards (labour markets don’t clear) Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less income and reduce their spending creating a negative knock-on effect. A paradox of thrift. In a recession, people lose confidence and therefore save more. By spending less this causes a further fall in demand. Keynesians argue greater emphasis on the role of aggregate demand in causing and overcoming a recession. Because of the different opinions about the shape of the aggregate supply and the role of aggregate demand in influencing economic growth, there are different views about the cause of unemployment.Classical economists argue that unemployment is caused by supply side factors – real wage unemployment, frictional unemployment and structural factors. They downplay the role of demand deficient unemployment.Monetarist economics is Milton Friedman's direct criticism of Keynesian economics theory, formulated by John Maynard Keynes. Simply put, the difference between these theories is that monetarist economics involves the control of money in the economy, while Keynesian economics involves government expenditures. Monetarists believe in controlling the supply of money that flows into the economy while allowing the rest of the market to fix itself. In contrast, Keynesian economists believe that a troubled economy continues in a downward spiral unless an intervention drives consumers to buy more goods and services.Both of these macroeconomic theories directly impact the way lawmakers create fiscal and monetary policies. If both types of economists were equated to motorists, monetarists would be most concerned with adding gasoline to their tanks, while Keynesians would be most concerned with keeping their motors running.Compared to the large empirical literature on the effects of monetary policy,
fiscal policy received much less attention in economic research until recently. This
lack of attention was at odds with the fact that several key public debates on the
role of fiscal policy were based on arguments eliciting the macroeconomic importance of government spending and taxation. The discussions around the Balanced
Budget Amendment in the US, the deficit limits of the Growth and Stability
Pact under EMU, or the possibility of having independent institutions running
fiscal policy are all based on the assumption that fiscal policy is an effective tool
for stabilizing business cycles fluctuations. The need for empirical evidence to
elucidate the issues in these debates spurred a large body of new research, which
can be loosely grouped in three categories. First, a group of economists focused
on specific episodes, fiscal consolidations, to study the macroeconomic impact of
large reductions in the budget deficit.1 The second line of research analyzed the
stabilizing capability of fiscal policy variables, i.e. to what extend the tax and
transfer system provides insurance against idiosyncratic regional shocks and how
well it stabilizes macroeconomic fluctuations in the aggregate.2 Finally, the dynamic effects of discretionary fiscal policy on macroeconomic
.By investigating the effects of shifts in fiscal policy stance on economic activity, this paper contributes to the third strand of research outlined above. The goal
of the paper is two-fold. First, we want to document some of the robust findings
on the dynamic effects of variation in government spending on key macroeconomic variables. We believe that the reported empirical evidence will be helpful
in current policy discussions. Second, we compare our empirical findings to the
predictions of the real business cycle model. We use this model as a benchmark
because of its popularity and more importantly because it illustrates clearly the
mechanisms behind the main theoretical responses.