Keynesian economists argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector in order stabilize output over the business cycle. Keynes advocated counter-cyclical fiscal policies (policies that acted against the tide of the business cycle). This means deficit spending and decreased taxes when an economy suffers from a recession and decreased government spending and higher taxes during boom times .
Counter-cyclical Fiscal Policies
Keynesian economists advocate counter-cyclical fiscal policies. This means increased spending and lower taxes during recessions and lower spending and higher taxes during economic boom times.
According to Keynesian economics, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Increased government spending will result in increased aggregate demand, which then increases the real GDP, resulting in an rise in prices. This is known as expansionary fiscal policy. Conversely, in times of economic expansion, the government can adopt a contractionary policy, decreasing spending, which decreases aggregate demand and the real GDP, resulting in a decrease in prices.
Highway Construction
The government can implement expansionary fiscal policy through increased spending, such as paying for the construction of new highways.
In instances of recession, government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. The government could stimulate a great deal of new production with a modest expenditure increase if the people who receive this money consume most of it. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in spending, and so on in a virtuous circle.
In addition to changes in spending, the government can also close recessionary gaps by decreasing income taxes, which increases aggregate demand and real GDP, which in turn increases prices. Conversely, to close an expansionary gap, the government would increase income taxes, which decreases aggregate demand, the real GDP, and then prices.
The effects of fiscal policy can be limited by crowding out. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment.