Hi, my name is Mariano Torras.
I'm Professor of Economics at Adelphi University in New York.
We are going to be doing a lecture series on macroeconomics.
What role does the government have in the macroeconomy?
In the preceding lecture,
we saw how, left to its own devices,
the economy is capable of slipping into recession or in rare cases, depression.
But that hardly suggests that the private sector is ineffective and that
the government should control production and make all allocation decisions.
Few indeed would subscribe to such an extreme view.
What is instead needed is an optimal balance between the private and public sectors.
We also saw in lecture number 8 that the effect of
a small autonomous change in investment is multiplied throughout the economy.
So if business cut back in spending,
the adverse effect on the economy is magnified.
Fortunately, the same applies the other way,
if the government seeks to stimulate the economy,
the necessary amount of the stimulus need only be a fraction of the intended effect.
The government might decide to spend money on building schools,
for example, therefore leading to an increase in employment.
Alternatively, it might decide to cut income taxes leading households with more money.
Both policies, in theory, boost spending,
output, and incomes, therefore, re-energizing the economy.
Fiscal policy refers to this government spending and tax policy.
Specifically, expansionary fiscal policy refers to when the government seeks to
push the economy out of a recession or high unemployment situation.
Contractionary fiscal policy is the opposite.
That is, when the government seeks to slow down
an overheating economy that is already at
full employment in order to keep inflation in check.
As we will see, both expansionary and contractionary fiscal policies
call for a judicious mix of government spending and taxes.
When there is a net leakage from the circular flow,
that is when savings exceed investment,
expansionary policy is called for.
Of course, we could simply allow the market for loanable funds to
rebalance as the interest rate declines until savings once again equal investment.
But we've already seen that the problem with such an approach is that the
re-balancing puts us at an equilibrium characterized by lower employment,
often not different from recession.
Expansionary fiscal policy then calls for stepping in
and producing a net injection to offset the leakage.
To explain, we need to re-visit the circular flow model from the previous lecture.