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Fiscal Policy: Overview, Tools & Types

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  • 0:01 What Is Fiscal Policy?
  • 0:51 Two World Views on Policy
  • 3:13 Tools of Fiscal Policy
  • 5:18 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

The Great Depression of the 1930s was one of the biggest economic disasters in history. This lesson describes fiscal policy, which helps to explain steps suggested by John Maynard Keynes to keep that from happening again.

What Is Fiscal Policy?

In the months following the stock market crash of 1929, the U.S. government was remarkably distant from any attempts to fix the economy. After all, crashes had happened before, and like all others, this one would eventually right itself. However, an economist named John Maynard Keynes sought to change all that.

Hate all this discussion of aggregate this and long-run that? You have Keynes to blame. Like the idea of getting a tax cut when the economy shrinks so that you have more money? You can thank Keynes for that. In short, Keynes developed much of our understanding on economics, specifically in the field of fiscal policy, or the actions that a government should take to maintain a steady growth rate for the economy.

Two World Views on Policy

Before the Great Depression, there was really only one view on fiscal policy, and that was that the government should keep its nose out of the economy. Calling themselves the Classical School of Economics, this branch referenced the thoughts of Adam Smith, the founder of modern economics, to justify that all that happened in an economy would be corrected by the 'invisible hand' of market forces.

Now let's return to the Great Depression. Who is to say that the Classical School was necessarily wrong? Their approach had worked on previous crashes, and while this one was much larger, that would only transfer to a longer period of waiting for the corrections to take place. Some people weren't willing to wait. John Maynard Keynes, a Cambridge-based economist, was primary among them. He said that it was possible to jump-start the economy to move it back towards full efficiency. To do that, Keynes argued, aggregate demand had to shift.

Calling themselves Keynesians, this school of thought heavily influenced the economic recovery of the 1930s. Relying on government spending and cuts to the tax rate, money was reintroduced to the economy. This government spending took forms like the Tennessee Valley Authority (TVA), Civilian Conservation Corps (CCC), and the Works Progress Administration (WPA). In fact, the ideology of an emphasis on government spending, when taken to the extreme, helped to allow the militant regimes in Germany, Italy, and Japan have relatively strong economies!

As a result, economists really don't spend time arguing if Keynesian practices work. Simply put, they do. However, the real question is if they are necessary. In fact, no one says that the Classical approach is wrong, as economies will eventually right themselves. It's just a matter of time that is the issue. Some Classical economists argue that in some cases that the treatment may be worse than the disease itself, and too much of a Keynesian approach can quickly force an economy into the rising prices of inflation.

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