Business cycles are the fluctuations in economic activity.
A recession is a decline in total output, income, employment, and trade usually lasting 6 months to a year, and marked by widespread contractions in many sectors of the economy.
Between 1929 and 1933:
real GNP fell by 30%
unemployment rate went from 3% to 25%
price level fell by 23%
nominal GNP fell by 50%
The most dramatic event of the Great Depression was the 1929 stock market crash.
There is no consensus on what caused the Great Depression:
7 good years of the Coolidge prosperity followed by 7 lean years
monetarist explanation - triggered by a collapse of the money supply; implies that interest rates should have risen but they didn't
Herbert Hoover - European financial collapse
Schumpeter - several economic cycles simultaneously reached low points
decline in investment spending
The average tax rate equals total taxes divided by pre-tax income. The marginal tax rate equals the taxes due from an additional dollar of income. The distinction between average and marginal tax rates affects people's labor supply decisions.
An increase in the average tax rate (holding the marginal tax rate constant) reduces after-tax income. With a lower income, people consume less leisure and work more. This is an income effect.
Suppose the marginal tax rate increases with the average tax rate held constant. With the average tax rate unchanged, there is no change in after-tax income and, so, no income effect. However, with a lower after-tax reward for each extra hour worked, a person wants to work less. This is a substitution effect.
In the absence of taxes, the free market works efficiently. Taxes change economic behavior, thereby reducing welfare. Tax-induced deviations from free market outcomes are called distortions. The higher the tax rate, the greater the distortion, and the loss of welfare is proportional to the square of the tax rate. A policy of tax rate smoothing, keeping a constant tax rate over time, minimizes the distortions.
Suppose taxes are cut by $100 per person. If the economy is at potential GDP, national saving declines only if consumption rises. Will it?
Consumption may not rise if people realize that a tax cut today must be financed by higher taxes in the future. The tax cut could be financed by a tax increase of (1+r)$100 next year. Taxpayers' ability to consume is the same with or without the tax cut. People will save the tax cut so they can pay off the future taxes. National saving will be unaffected.
What if the higher future taxes are to be paid by future generations? Then people might consume more today because they wouldn't have to pay the higher future taxes.
If people care about their children, they will increase their bequests to their children so their children can pay the higher future taxes. After all, if people wanted to consume at their children's expense they could have lowered their planned bequests. So, why should a tax cut cause people to consume at their children's expense?
Empirically, there seems to be little relationship between government budget deficits and national saving.
Why might Ricardian Equivalence fail?
borrowing constraints - a tax cut financed by higher future taxes is like a loan from the government
shortsightedness
failure to leave bequests
non-lump sum taxes - affect economic deicsions