06.27.10

Fiscal Policy

Posted in Economics at 9:15 am

The best way to illustrate how fiscal policy can help during a recession is with a Production Possibilities Frontier (PPF).  This is particularly effective for those who get hung up on crowding out effects (e.g., the Treasury View).

PPF

PPF

The PPF can be drawn several different ways.  One axis can represent consumption spending while the other represents investment spending.  Or government spending vs private sector spending.  Or guns vs butter.  In all cases, the frontier represents a technology constraint and shows the tradeoff between two choices.  If the economy is operating on the frontier (by definition it can’t be outside the frontier) then any increase in consumption necessarily implies a decrease in investment and vice versa, any increase in government spending necessarily implies a decrease in private spending and vice versa, any increase in the production of guns necessarily implies a decrease in the production of butter and vice versa.  This is what Keynes was talking about when he spoke of the classical view.

Here’s the problem with the classical view.  Operating on the frontier means that the economy is operating at full capacity.  All labor and all capital is fully employed.  During a recession, the economy is NOT operating at full capacity.  There is unemployed labor and unemployed capital.  By definition, the economy is not operating on the PPF, rather it is operating inside of it.  Therefore it is possible to increase consumption and investment simultaneously, government and private spending simultaneously, guns and butter simultaneously.  Doing so represents a move towards the PPF, which in turn means higher capacity utilization, and greater employment of resources.  An economy operating on the PPF is a special case – the general case is that the economy can be operating anywhere inside the PPF or on the PPF but not outside of it.  Keynes recognized this (hence the title of the GENERAL Theory) and then went on to explain the determinants of where the economy will find equilibrium and the policy choices that could move the economy toward the full employment equilibrium (on the PPF).

1 Comment »

  1. liberal said,

    06.27.10 at 10:20 am

    ruetheday—I used to post, and read your posts, over at sci.econ. I was wondering if you could send me an email so I could contact you directly. (I found a link here from nakedcapitalism.com.)

    An email I use occasionally is
    em nine em cue at live dot com
    (Replace tokens 1 through 5 and 7 by single characters based on their sound.)

    I’d say what my handle on usenet was at sci.econ, but I’d rather save that for a reply to your email so you can verify who I am that way. I will say that I’m interested in the economics of rent.

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