Question

What kind of policies (under Fiscal policy) might you suggest to the government? Mention three. Consider the economic principle held by Classical economists: The economy always returns to its potential in the long run. What are Keynes’s criticisms of this economic principle?

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Answer 1

There are three main types of fiscal policy:

1. Neutral: This type of policy is usually undertaken when an economy is in equilibrium. In this instance, government spending is fully funded by tax revenue, which has a neutral effect on the level of economic activity.
2. Expansionary: This type of policy is usually undertaken during recessions to increase the level of economic activity. In this instance, the government spends more money than it collects in taxes.
3. Contractionary: This type of policy is undertaken to pay down government debt and to cap inflation. In this case, government spending is lower than tax revenue.

In classical economic theory, it is argued that output and prices will eventually return to a state of equilibrium, but the Great Depression seemed to counter this theory. Output was low and unemployment remained high during this time. The Great Depression inspired Keynes to think differently about the nature of the economy. From these theories, he established real-world applications that could have implications for a society in economic crisis.

Keynes rejected the idea that the economy would return to a natural state of equilibrium. Instead, he argued that once an economic downturn sets in, for whatever reason, the fear and gloom that it engenders among businesses and investors will tend to become self-fulfilling and can lead to a sustained period of depressed economic activity and unemployment. In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand.

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