275 Why It Matters: Policy Application

Why use an understanding of the strengths and weakness of fiscal and monetary policy to determine an appropriate stabilization policy for a given macroeconomic situation?

The module really ties together everything we’ve learned about macroeconomics. In earlier modules we introduced the concepts of fiscal and monetary policy. In this module, we examine the two types of policy in more detail, incorporating all the pros and cons of the real world. By extension, we will be evaluating the policy prescriptions of Keynesian and Neoclassical economics. As you work through this module, use the following questions to guide your thinking:

• Under what circumstances do fiscal and monetary policy work well or not so well at managing the economy?
• For the activist Keynesians, what are the limits to fiscal and monetary policy that you would endorse, and why?
• For the laissez-faire Neoclassicals, what is the minimalist fiscal and monetary policy that makes sense, and why?

Suppose you are asked to provide guidance about the macro economy in a given situation. Knowing what you know about the strengths and weaknesses of using fiscal or monetary policy, what would you recommend? For example, suppose after a period of solid economic growth, low unemployment, and modest inflation, the economy slows down a bit and unemployment shoots up several percentage points. What should be done about that?

LEARNING OUTCOMES

• Understand the Keynesian view on changes in government spending and taxation; define the multiplier effect; define the crowding out effect and explain why it occurs and how it reduces the fiscal multiplier; define the Keynesian concept of the Liquidity Trap and explain why it occurs and how it reduces the effectiveness of monetary policy
• Understand the effects of tax and spending policy from a neoclassical perspective; define and give examples of supply-side economics; explain the types of lag times that often occur when solving economic problems; describe the neoclassical long-run aggregate supply curve; understand and describe the emergence of New Classical Economics, along with its main tenets; define Ricardian Equivalence
• Identify appropriate macro policy options in response to the state of the economy; understand the effectiveness and limitations of fiscal and/or monetary policy for a given state of the economy; choose an appropriate fiscal and monetary policy for a given state of the economy