Keynesian Fiscal Policy on the U.S. Economy,

¶ … Keynesian fiscal policy on the U.S. economy, we first need to understand that basics of this macroeconomic model. It is also important to remember that this economic model came at a time when the Great Depression had a grip on the U.S. industry and economy.

Economists of the 1930s called for further wage cuts to reduce unemployment and supported higher taxes so people would not "overconsume." John Maynard Keynes's theory was the total opposite and quite simple and practical.

If companies believe they can sell extra output, then they will hire more laborers. Conversely, if demand for their products declines, then they will cut back on production and lay workers off. The downside of layoff workers is that these consumers will have less money to spend and have a negative impact on demand, giving rise to continued unemployment.

This puts the economy is a vicious cycle of lowered demand and high unemployment. Companies by themselves cannot reverse this pattern and that's when government intervention is required. The government needs to intervene and push the economy back into a cycle of high demand and employment.

Of particular importance in the early years of the role of fiscal policy was that many of the early Keynesians (including Keynes himself) objected to the claim that the monetary policy was enough by itself to promise full employment. Interest rates had fallen considerably during the 1930s but even that was no enough to spur private investment. The logic here was easily understandable because even with so much excess capacity, the incentives to build were very little, even with cheap financing. That's why Keynesian fiscal policy focused on increased government spending and lowering taxes to help fill the gap.

It really was the impact of the Great Depression that that got Keynes thinking about income vs. expenditure models and their affect on the U.S. economy. The macroeconomists of the 1930's thought of events like the Great Depression as a "business cycle." Keynes' believed that was that changes in the autonomous components in expenditure, and saving and investment are the precipitators of economic fluctuations. His basic premise was that unemployment and depression lower consumption and thus production, which leads to increased unemployment and deeper depression. An upturn can only occur after inventories are depleted. But unemployment and depression can plague an economy for an undefined period of time.

According to Laurence Seidman, "In the three decades following the publication of John Maynard Keynes's General Theory of Employment, Interest, and Money in 1936, counter cyclical fiscal policy achieved a gradual ascendancy within the economics profession and in the practical realm of economic policy. By the 1960s, it was widely agreed that fiscal policy should be used to counter fluctuations in the economy. To counter a recession, taxes should be cut, cash transfer payments (such as unemployment insurance benefits) increased, and government purchases of goods and services (such as public works construction) increased. But the past three decades have witnessed the decline and fall of counter-cyclical fiscal policy in both theory and practice. The majority of economists have concluded that monetary policy alone should be used to stabilize the economy, and a minority have argued that the government should not use either monetary or fiscal policy for that purpose. Whereas Congress enacted a major fiscal stimulus package to counter the 1975 recession, it did not even consider a serious package in the 1991 recession. "

Many of the Neoclassical economists disagreed with Keynes's theories and believed policies based on his ideas further distorted markets; radical economists regarded these policies as "Band-Aids" -- that would not sustain a healthy economy in the longer run. In Keynes model, changes in independent spending can shift the balance of income and so change the level of production and employment. Any of the three components of autonomous spending, including consumption, investment and net exports can have this effect. In each case, the change in equilibrium income will be larger than the change in the autonomous spending component.

In times of economic crisis, "it is crucial that the public believe that the government is able and eager to use aggressive fiscal policy should a depression threaten. If the economy is hit with a shock that throws it into a recession, will households and business managers expect the economy to recover, or will they expect the recession to deepen? If they expect the government to act aggressively and effectively to prevent depression, households and business managers will continue to spend, and this behavior will sustain aggregate demand, in itself preventing depression. On the other hand, if they expect the government to be passive, they may cut their spending, thereby deepening the recession. In the three decades following Keynes's General Theory, economists emphasized the importance of the public's expectations about output and employment. In the past three decades, economists have instead emphasized the public's expectations about inflation and have often neglected the public's expectations about output and employment. Both expectations are important to the stability of the economy: Private behavior will be stabilizing when the public expects the government to act aggressively to combat either inflation or recession." Keynesianism actually achieved a middle ground that conceded little to its political critics: markets work, it claimed, provided there is full employment, but the market itself cannot guarantee that on its own; furthermore, government efforts are not futile but, tended carefully and continuously, they can in fact help sustain a permanently high level of employment and stability.

After the 1940s, the real impact of Keynes's model on public policy began to be felt. Because the government had intervened with by pump priming and a government-led war, people began to look at Keynesian claims about the ability of governments to achieve and maintain full employment.

In the United States, in 1946, the U.S. Congress passed the "Employment Act" emphasizing government's responsibility to seek and maintain "maximum employment" (the word "full" was deleted by some nervous congressmen, and the final text was littered with conservative escape clauses). A Council of Economic Advisors (CEA) was set up around the same time. Even in its early years, it was composed and staffed by economists somewhat sympathetic with the Keynesian Revolution. By the time the Kennedy administration took office, the CEA was composed of prominent Keynesians outright, with Walter Heller, Kermit Gordon and James Tobin the CEA seats and Paul Samuelson, John Kenneth Galbraith, Arthur Okun and Seymour Harris in the background.

In the post-war Western world, fiscal policy became the norm and monetary policy was slowly identified as being an important influence on output and therefore a potentially effective policy tool.

The Gold Standard no longer was revered as the only way to go and was eventually abandoned altogether. Keynes himself was responsible for setting a new international monetary order in 1946.

For the next few decades, political consensus on economic policy was remarkably uniform. By 1970, even Richard Nixon would declare "I am now a Keynesian." The violent business cycle, it was thought, had been tamed - and, in many ways, it actually was. During this period, the Western world achieved an unprecedented period of prosperity and the developing nations of Latin America, Africa and Asia looked forward with confidence. It seemed as if the vision Keynes laid out in his "Economic Possibilities for Our Grandchildren" (1930, Nation and Atheneum) was approaching even faster than he had anticipated. Of course, few predicted the unraveling that would happen in the 1970s.