Policy Making
10. Fiscal policy

What do you advise the President to do when the economy seems to be faltering? The principle underlying Keynesian and Lernerian fiscal policy is functional finance-Lerner's phrase (see Heterodox Box, Chapter ***). Government should keep its eye on the economic results of its budgeting actions instead of simply maintaining a balanced budget. If a deficit can have positive economic results, create a deficit; when the economy gets overheated, let the government have a surplus.

Functional finance implies that the government budgets its expenditures and taxes with the economy in mind, in contrast to financing according to merely sound accounting principles.

In the mind of the first Keynesian economists, fiscal policy was a way to fine-tune the economy. The "fine-tuning" metaphor-another lasting phrase of Lerner's invention-is revealing, since it depicts the economy as an instrument that can be adjusted just right with a smart tuner. In a slightly different metaphor Keynesian economists imagined the politicians at the steering wheel, the economists being the automotive engineers who designed how the steering works. Figure 33-2 shows the Tinbergen model for fiscal policy.

Figure 33-2 Fiscal Economic Policy according to the Tinbergen Model
  • Tastes
    • Ultimate Goals:
      - Domestic Stability
      - Low Unemployment
      - Low Inflation
      - High Economic Growth
  • Constraints and Tools
    • Relevant Theory: the Keynesian Model
    • Intermediate Targets
      - Aggregate Demand
    • Policy Instruments
      - Levels of Taxes and Governmental Expenditures (i.e. the Government Deficit)