In the wake of the Great Depression, economists started advocating the use of government policy to improve the functioning of the macroeconomy. There are two kinds of government policy. Monetary policy refers to changes in interest rates and other tools that are under the control of the monetary authority of a country (the central bank).Fiscal policy refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country’s lawmakers. Stabilization policy is the general term for the use of monetary and fiscal policies to prevent large fluctuations in real gross domestic product (real GDP).
In the United States, the Federal Reserve Bank controls monetary policy, and fiscal policy is controlled by the president, the Congress, and state governments. In the countries of the European Union, monetary policy is controlled by the European Central Bank, and fiscal policies are controlled by the individual governments of the member countries.
Keynes suggested that the cause of the Great Depression was an unusually low level of aggregate spending. This diagnosis suggests an immediate remedy: use government policies to increase aggregate spending. Because
change in GDP = multiplier × change in autonomous spending,
any government policy that increases autonomous spending will, through this equation, also increase GDP. There are many different policies at the disposal of the government, but they are similar at heart. The idea is to stimulate one of the components of aggregate spending— consumption, investment, government purchases, or net exports.
One fiscal policy measure is an increase in government purchases. Suppose the government increases its expenditure—perhaps by hiring more teachers, buying more tanks, or building more roads. This increases autonomous spending and works its way through the economy, just as in our earlier discussion of a decrease in autonomous consumption—except now we are talking about an increase rather than a decrease. If the government spends an extra dollar, this immediately expands income by that dollar. Extra income leads to extra spending, which leads to further increases in output and income. The process continues around and around the circular flow.
Imagine that, as before, the marginal propensity to spend is 0.8, so that the multiplier is 5. If the government increases expenditure on goods and services by $1 billion, overall GDP in the economy will increase by $5 billion. Thus to offset the decrease in real GDP of about $90 billion between 1929 and 1933, assuming a marginal propensity to spend of 0.8, the federal government should have increased government spending by $18 billion. The multiplier is a double-edged sword. It has the bad effect that it can turn small decreases in spending into big decreases in output. But it also means that relatively small changes in government spending can have a big effect on output.
Tax cuts are another way to stimulate the economy. If households have to pay fewer taxes to the government, they are likely to spend more on consumption goods. This form of policy intervention has been used over and over again by governments in the United States and elsewhere. Tax cuts, like government spending, must be paid for. If the government spends more and taxes less, then the government deficit increases. The government must borrow to finance such fiscal policy measures. [***Chapter 12 "Income Taxes" and Chapter 14 "Balancing the Budget" have more to say about fiscal policy.***]
The central bank can use monetary policy to affect aggregate spending. Monetary policy operates through changes in interest rates, which are—in the short run at least—under the influence of the central bank. Lower interest rates make it cheaper for firms to borrow, which encourages them to increase investment spending. Lower interest rates likewise mean lower mortgage rates, so households are more likely to buy new homes. Lower interest rates may encourage households to borrow and spend more on other goods. And lower interest rates can even encourage net exports. [***The link from interest rates to net exports is complicated because it involves changes in exchange rates. You do not need to worry here about how it works. We explain it, together with other details of monetary policy, in Chapter 10 "Understanding the Fed".***]
- 801 reads
