Two Sides of Fiscal Policy

In our one example of fiscal policy so far, we considered an increase in government purchases as a means of increasing aggregate demand in order to move from an unemployment equilibrium to a full employment equilibrium. That kind of fiscal policy was certainly on the agenda when Keynes was writing, during the Great Depression of the 1930's, and is probably the kind of policy most widely understood as Keynesian. But the Keynesian approach, and even the Simple Keynesian Model, offers a much wider range of possibilities. Keynes himself, in writing on "How to Pay For The War" (World War II) recognized that the inflationary conditions of wartime would call for quite different policies than the Great Depression.

As we have seen, taxes also have multiplier effects. Since the tax multiplier is negative, a reduction in taxes would increase aggregate demand. In the examples we have been using, every $1 decrease in taxes would increase aggregate demand by $2.33. Advocates of tax cuts often support their position by saying that the tax cuts would stimulate increased demand and therefore increased production. This is pure Keynesian economics and is consistent with the Simple Keynesian Model.

More to the point, a Keynesian (even a very simple one) would not argue for increased aggregate demand in all circumstances. Keynesian economics says that equilibrium can differ from full employment, but the difference could go either way -- equilibrium production might be either more or less than full employment production. Thus Keynesian economics recognizes two kinds of gaps between equilibrium production and full employment:

Recessionary Gaps

A recessionary gap exists when production is less than full employment production. It might also be called a "contractionary" gap, since production is "contracted" below full employment. Unemployment is likely to result, and the appropriate policy is one that would "expand" aggregate demand, an "expansionary" policy. "Expansionary" fiscal policies include increases in government purchases and cuts in taxes, or some combination of these. An increase in the size of a balanced government budget would also be expansionary. The example of fiscal policy we discussed a few pages back was a contractionary gap remedied by an increase in government purchases.

Inflationary gaps.

An inflationary gap exists when equilibrium income is greater than full employment income. In such a case, businessmen would compete against one another to get resources with which to produce the output that is demanded, and costs would rise, with prices following them up. An inflationary gap could also be called an expansionary gap. An appropriate policy for an expansionary gap would be a policy that reduces, or "contracts." aggregate demand. Reductions in government purchases, increases in taxation, and reductions in the size of a balanced budget would be examples of contractionary policy.

To further illustrate fiscal policy, let's consider a numerical example of an inflationary gap.

An Inflationary Gap