501

Aggregate Expenditures

19

502

Madawaska, Maine, near the northern end of U.S. 1 that extends all the way south to Key West, Florida, is like many other idyllic small towns in the United States—picturesque, friendly, and highly dependent on one industry to provide jobs for its residents. For Madawaska, it is the local paper mill, which provides jobs to 620 of its 4,100 residents. The salaries earned by its workers help to keep the rest of the town employed, including workers in restaurants and cafés, pharmacies, banks, and gas stations that serve the paper mill workers and their families.

During the depth of the 2007–2009 recession, when Madawaska’s paper mill was on the brink of closure, not only did its workers face potential unemployment, but so did the rest of the community, which depends on people with jobs at the paper mill to support their businesses. Towns such as Madawaska highlight the interdependency of the economy in which the loss of one job results in a reduction in spending that affects other jobs. In 2010 the workers at the paper mill took the unusual step of accepting an 8.5% wage cut in order to keep the company (and town) from closing down. And the plan worked—the plant survived and was sold to an investment firm in 2013 that promised to keep the paper mill running in Madawaska, where it remains in operation today.

The economic crisis that Madawaska faced during the last recession was one that many cities, big and small, experienced. As unemployment rose, people had less money to spend on clothing, electronics, travel, and cars, which caused a chain reaction downward in consumption, leading to further unemployment and slow or negative economic growth. This chain reaction is what John Maynard Keynes alluded to when he published The General Theory of Employment, Interest and Money in 1936, which discussed the importance of aggregate spending and the government’s role in stabilizing the macroeconomy.

Today, the U.S. economy (along with the majority of its cities) has recovered from the last recession. As employment opportunities grew during the recovery, more money was earned and subsequently spent, which generated more economic activity and jobs. The chain reaction in recent years has worked in a positive direction. Sometimes, however, consumers and businesses alone cannot pull an economy out of recession, and government policies are needed to speed up growth. But how should government act and to what extent should it act?

These are the more contentious questions that are debated today. Stimulus packages, tax cuts, farm subsidies, laws and regulations, and even financial aid for college students are all part of a huge arsenal of tools available to government policymakers. The goal of government stimulus programs is to put money into the hands (through jobs, tax cuts, and cash benefits) of those most likely to spend it in their communities, thus carrying a positive ripple effect through to other businesses that depend on consumer spending.

But Keynesian policies have not been without their critics as the size of government grew. Spending by government (federal, state, and local) has increased from 10% of GDP in the 1930s to over 30% today as the size and scope of government programs expand. Although many people benefit from these programs, some believe government has overreached and they would prefer something smaller and simpler.

This sort of thinking is not new. In fact, over a century ago, government policies were rarely used to intervene in the workings of the economy, even when the economy entered a downturn. Classical economists, as they are called, viewed the role of the government as providing the necessary framework upon which the market could operate—maintaining competition, providing central banking services, providing for national defense, administering the legal system, and so forth. But government was not expected to play a role in promoting full employment, stabilizing prices, or stimulating economic growth—the economy was supposed to do this on its own. The belief at the time was that economic downturns were self-correcting, meaning that if the economy were left alone, the forces of supply and demand would naturally bring the economy back into equilibrium.

The classical perspective was challenged during the Great Depression by Keynes, who turned away from the classical framework with its three separate and distinct competitive markets operating through prices, wages, and interest rates. He focused instead on the economy as a whole and on aggregate spending.

In this chapter, we develop the aggregate expenditures model, which is commonly referred to as the Keynesian model. It can be used to analyze short-run macroeconomic fluctuations and how policymakers counteract the effects caused by the business cycle. Keynes’s focus was on aggregate spending, and how consumption spending is a key component to explaining how the economy reaches short-term equilibrium employment, output, and income. Using this model, we will see why an economy can get stuck in an undesirable place, and why policies are useful in smoothing out the business cycle.