The term "economic policy" is used to refer to macroeconomic policies used by governments to stabilize the overall economy. Until the Great Depression of the 1930s and the advent of Keynesian economics, there were no conscious attempts on the part of the U.S. government to stabilize the economy. Both economists and politicians believed in classical economics, which held that there was no need for economic policy at all. The classical economists had argued that the self-adjusting market mechanism would restore full employment in the economy, should the economy deviate from the full employment path for some reason. The experience of the Great Depression, however, showed that market forces did not work as well as the classical economists had believed. The unemployment rate in the United States rose to above 25 percent of the workforce. Hard-working people were out in the street looking for nonexisting jobs. Wages fell quite substantially. But the lower wages did not reestablish full employment.
British economist John Maynard Keynes (1883-1946) argued that self-adjusting market forces could take a long time to restore full employment. He predicted that an economy can be stuck at a high level of unemployment for a prolonged period, leading to untold miseries. Keynes explained that classical economics suffered from major flaws. Wages and prices are not as flexible as classical economists assumed—in fact, nominal wages tend toward the downward direction. Keynes further argued that classical economists had ignored a key factor that determined the level of output and employment in the economy—the "aggregate demand" for goods and services in the economy from all sources (consumers, businesses, government, and foreigners). Producers produce (and provide employment in the process) to meet the demand for their goods and services. If the level of aggregate demand is low, the economy would not create enough jobs and unemployment can result. In other words, the free working of the macroeconomy does not guarantee full employment—deficient aggregate demand can cause unemployment. Thus, if the aggregate private demand (i.e., the aggregate demand excluding government spending) falls short of the demand level needed to generate full employment, the government should step in to take up the slack.
The central issue underlying Keynesian thought was that those who have incomes demand goods and services and, in turn, help to create jobs. The government should thus find a way to increase aggregate demand.
One direct way of increasing aggregate demand is to increase government spending. Increased spending on a government project such as reforestation will generate jobs and incomes for the persons employed on the project. This, in turn, would provide demand for goods and services from private producers and generate additional employment in the private sector. Keynesian economists thus recommend that the government should use fiscal policy (which includes decisions regarding both government spending and taxes ) to make up for the shortfall in private aggregate demand and to create jobs in the private sector machine. Keynesian economists went so far as to recommend that it may be worthwhile for the government to employ people to dig holes and to fill them up.
The administration of Franklin D. Roosevelt followed Keynesian recommendations, although reluctantly, and embarked on a variety of government programs aimed at boosting incomes and aggregate demand. As a result, the economy started improving. The really powerful push to the depressed U.S. economy, however, came when World War II broke out. The war generated such an enormous demand for U.S. military and civilian goods that factories in the United States operated multiple shifts. No serious unemployment was seen in the U.S. economy for a long time to come.
Modern Keynesians (also known as neo-Keynesians) recommend monetary policy, in addition to fiscal policy, to manage the level of aggregate demand. Monetary policy essentially refers to the manipulation of the nation's money supply by the Federal Reserve Bank (the central bank of the United States) in order to influence the state of the economy. The Federal Reserve employs several methods to influence the level of money supply in the economy. The most favored and the frequently used method is called open market operations.
Open market operations is the instrument used most frequently by the Federal Reserve to manipulate the money supply. Through open market operations, the Federal Reserve manipulates the reserves in the banking system by buying or selling Treasury securities in the open market in which major commercial banks (known as the money center banks) participate. When the Federal Reserve sells Treasury bonds to banks, it receives cash in exchange—the excess reserves in the banking system go down and thus the money supply will, potentially, go down also. The opposite is the case when the Federal Reserve buys Treasury securities from the banking system. The Federal Reserve uses open market operations to manipulate the nation's money supply on a regular basis—it is considered the main instrument of monetary policy.
Monetary policy affects aggregate demand in the Keynesian system by influencing private investment and consumption demand. An increase in the money supply, for example, leads to a decrease in the interest rate . This lowers the cost of borrowing and thus increases private investment and consumption, boosting aggregate demand in the economy.
An increase in aggregate demand through the use of monetary and fiscal policies under the Keynesian system, however, not only generates higher employment but also leads to higher inflation . This causes a policy dilemma—how to strike a balance between employment and inflation. According to laws that were enacted following the Great Depression, the policy makers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability.
While monetary and fiscal policies attempt to stabilize the economy by manipulating the level of aggregate demand, supply-side economists have advocated the manipulation of supply-side factors to promote growth in the economy.
While supply-side economics became popular during the Reagan era, it had been a part of the U.S. macroeconomic policies for some time. Supply-side theory was also rooted in classical economics, even though it accepted some Keynesian policies of demand management. Basically, supply-siders emphasize enhancing economic growth by augmenting the supply of factors of production (such as labor and capital). This would be accomplished through increased incentives mainly in the form of reduced taxes and regulations. Reagan, for example, used a major tax cut as a part of his fiscal policy. The supply-siders, in general, want a greater role for the market forces and a reduced role for the government.
The main goal of monetary and fiscal policies was to stabilize the macroeconomy—reducing or eliminating economic fluctuations or business cycles (as they are commonly known). Business cycles, however, have not been conquered to the fullest extent. After all, the most recent downturn ended only in 1992.
Business cycles have been with the U.S. economy for a long time. After the Great Depression of the 1930s, it was realized that the government should use macroeconomic policies—monetary and fiscal policies—to manipulate the level of aggregate demand and to stabilize the economy around full employment with price stability. One of the two macroeconomic policy instruments, fiscal policy, is conducted by the Congress and the president. The conduct of monetary policy is left to the Federal Reserve Bank, an independent federal institution. The U.S. experience has shown that the burden of stabilizing the economy has fallen disproportionately on the Federal Reserve—fiscal policy is said to be slow to respond and less decisive due to political conflicts among policy makers. Despite many shortcomings and imperfections of monetary and fiscal policies, the evidence seems to suggest that they have had a moderating influence on business cycles. While business fluctuations continue to exist in the U.S. economy, recessions in the post-Depression period have been relatively modest. While not all economists subscribe to the conclusion that the macroeconomic policies have moderated business cycles, these policies continue to be used to stabilize the economy.
While aggregate demand-based economic policies are widely used across the globe, economists disagree on the exact effects of monetary and fiscal policies on an economy. There are two major groups of economists—those who oppose the use of macroeconomic policies to stabilize the economy and those who favor it. Two well-known opposing schools of thought— monetarism and Keynesian economics—are utilized here to represent the views of the two opposing groups, respectively.
Monetarists believe that fiscal policy does not have a significant effect on output and employment in the economy. According to them, when a government conducts fiscal policy through increasing government spending, financed by borrowing, it raises interest rates in the process. As a result, private expenditures (both consumption and investment) get crowded out. Thus, the increased government spending comes at the expense of private sector spending, offsetting the ultimate effects of the fiscal policy on the economy.
Monetarists believe that the effects of monetary policy (such as increasing the money supply) on real variables, such as output and employment, are short-lived. They assert that an increase in the money supply only affects the price level in the long run. Monetarists also believe that the conduct of monetary policy by the Federal Reserve is the primary cause of instability and fluctuations in the economy. They are thus against manipulating the money supply to influence the levels of output and employment in the economy. Instead, they would like the money supply to grow at a low constant rate, so as to keep the price level relatively constant.
Keynesian economists, on the other hand, recommend using both fiscal and monetary policies to favorably influence output and employment, and to reduce inflation. They believe that market forces are slow to adjust. Therefore, if the economy is experiencing high unemployment, an expansionary monetary or fiscal policy can be used to increase the level of employment. An increase in the money supply implies greater resources available for lending, which reduces interest rates (the cost of borrowing). At lower interest rates, total demand (or aggregate demand) in the economy increases, as consumers and businesses spend more on consumption and investment, respectively. Increased demand for goods and services requires increased production, which in turn requires higher level of employment. The technique works, according to Keynesian economists, in the opposite direction in an inflationary environment. Reducing the money supply and increasing the interest rate decreases the level of aggregate demand in the economy, which puts downward pressure on the price level. The basic Keynesian logic is: if we have a way to improve the economy, why not do it? According to Keynesians, fiscal policy expands or contracts demand even more directly. Thus, a tax cut would stimulate aggregate demand by increasing disposable income in the hands of consumers. Similarly, increased government spending would accomplish this by adding to the existing level of private demand.
Keynesian policy recommendations have been widely adopted throughout the world. Both monetary policy and fiscal policy (that use government spending and taxes to influence the level of aggregate demand) are used to improve economies (that is, to attempt to stabilize them at or near full employment with low inflation). In the United States, laws have been enacted that require the government to achieve full employment if it is considered desirable, given the economic circumstances.
SEE ALSO : Federal Reserve System
[ Anandi P. Sahu , Ph.D. ]
Froyen, Richard T. Macroeconomics: Theories and Policies. 6th ed. Upper Saddle River, NJ: Prentice Hall, 1998.
Gordon, Robert J. Macroeconomics. 7th ed. Reading, MA: Addison-Wesley, 1998.
Mankiw, N. Gregory. Principles of Macroeconomics. Dryden Press, 1998.
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