MODULE 20: Economic Policy and the Aggregate Demand

Macroeconomic Policy

Some people use Keynesian economics as a synonym for left-wing economics—but the truth is that the ideas of John Maynard Keynes have been accepted across a broad range of the political spectrum.

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Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

We’ve just seen that the economy is self-correcting in the long run: it will eventually trend back to potential output. Most macroeconomists believe, however, that the process of self-correction typically takes a decade or more. In particular, if aggregate output is below potential output, the economy can suffer an extended period of depressed aggregate output and high unemployment before it returns to normal.

This belief is the background to one of the most famous quotations in economics: John Maynard Keynes’s declaration, “In the long run we are all dead.” Economists usually interpret Keynes as having recommended that governments not wait for the economy to correct itself. Instead, it is argued by many economists, but not all, that the government should use fiscal policy to get the economy back to potential output in the aftermath of a shift of the aggregate demand curve. This is the rationale for active stabilization policy, which is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

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Can stabilization policy improve the economy’s performance? As we saw in Figure 18.4, the answer certainly appears to be yes. Under active stabilization policy, the U.S. economy returned to potential output in 1996 after an approximately five-year recessionary gap. Likewise, in 2001, it also returned to potential output after an approximately four-year inflationary gap. These periods are much shorter than the decade or more that economists believe it would take for the economy to self-correct in the absence of active stabilization policy. However, as we’ll see shortly, the ability to improve the economy’s performance is not always guaranteed. It depends on the kinds of shocks the economy faces.

Policy in the Face of Demand Shocks

Imagine that the economy experiences a negative demand shock, like the one shown by the shift from AD₁ to AD₂ in Figure 19.5. Monetary and fiscal policy shift the aggregate demand curve. If policy makers react quickly to the fall in aggregate demand, they can use monetary or fiscal policy to shift the aggregate demand curve back to the right. And if policy were able to perfectly anticipate shifts of the aggregate demand curve and counteract them, it could short-circuit the whole process shown in Figure 19.5. Instead of going through a period of low aggregate output and falling prices, the government could manage the economy so that it would stay at E₁.

Why might a policy that short-circuits the adjustment shown in Figure 19.5 and maintains the economy at its original equilibrium be desirable? For two reasons: First, the temporary fall in aggregate output that would happen without policy intervention is a bad thing, particularly because such a decline is associated with high unemployment. Second, price stability is generally regarded as a desirable goal. So preventing deflation—a fall in the aggregate price level—is a good thing.

Does this mean that policy makers should always act to offset declines in aggregate demand? Not necessarily. As we’ll see, some policy measures to increase aggregate demand, especially those that increase budget deficits, may have long-term costs in terms of lower long-run growth. Furthermore, in the real world policy makers aren’t perfectly informed, and the effects of their policies aren’t perfectly predictable. This creates the danger that stabilization policy will do more harm than good; that is, attempts to stabilize the economy may end up creating more instability. We’ll describe the long-running debate over macroeconomic policy in later modules. Despite these qualifications, most economists believe that a good case can be made for using macroeconomic policy to offset major negative shocks to the AD curve.

Should policy makers also try to offset positive shocks to aggregate demand? It may not seem obvious that they should. After all, even though inflation may be a bad thing, isn’t more output and lower unemployment a good thing? Again, not necessarily. Most economists now believe that any short-run gains from an inflationary gap must be paid back later. So policy makers today usually try to offset positive as well as negative demand shocks. For reasons we’ll explain later, attempts to eliminate recessionary gaps and inflationary gaps usually rely on monetary rather than fiscal policy. For now, let’s explore how macroeconomic policy can respond to supply shocks.

Responding to Supply Shocks

In panel (a) of Figure 19.3, we showed the effects of a negative supply shock: in the short run such a shock leads to lower aggregate output but a higher aggregate price level. As we’ve noted, policy makers can respond to a negative demand shock by using monetary and fiscal policy to return aggregate demand to its original level. But what can or should they do about a negative supply shock?

In contrast to the case of a demand shock, there are no easy remedies for a supply shock. That is, there are no government policies that can easily counteract the changes in production costs that shift the short-run aggregate supply curve. So the policy response to a negative supply shock cannot aim to simply push the curve that shifted back to its original position.

In addition, if you consider using monetary or fiscal policy to shift the aggregate demand curve in response to a supply shock, the right response isn’t obvious. Two bad things are happening simultaneously: a fall in aggregate output, leading to a rise in unemployment, and a rise in the aggregate price level. Any policy that shifts the aggregate demand curve alleviates one problem only by making the other problem worse. If the government acts to increase aggregate demand and limit the rise in unemployment, it reduces the decline in output but causes even more inflation. If it acts to reduce aggregate demand, it curbs inflation but causes a further rise in unemployment.

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Is Stabilization Policy Stabilizing?

We’ve described the theoretical rationale for stabilization policy as a way of responding to demand shocks. But does stabilization policy actually stabilize the economy? One way we might try to answer this question is to look at the long-term historical record. Before World War II, the U.S. government didn’t really have a stabilization policy, largely because macroeconomics as we know it didn’t exist, and there was no consensus about what to do. Since World War II, and especially since 1960, active stabilization policy has become standard practice.

So here’s the question: has the economy actually become more stable since the government began trying to stabilize it? The answer is a qualified yes. It’s qualified because data from the pre–World War II era are less reliable than more modern data. But there still seems to be a clear reduction in the size of economic fluctuations.

The figure on the right shows the number of unemployed as a percentage of the nonfarm labor force since 1890. (We focus on nonfarm workers because farmers, though they often suffer economic hardship, are rarely reported as unemployed.) Even ignoring the huge spike in unemployment during the Great Depression, unemployment seems to have varied a lot more before World War II than after. It’s also worth noticing that the peaks in postwar unemployment in 1975 and 1982 corresponded to major supply shocks—the kind of shock for which stabilization policy has no good answer.

It’s possible that the greater stability of the economy reflects good luck rather than policy. But on the face of it, the evidence suggests that stabilization policy is indeed stabilizing.

Source: C. Romer, “Spurious Volatility in Historical Unemployment Data,” Journal of Political Economy 94, no. 1 (1986): 1–37 (years 1890–1928); Bureau of Labor Statistics (years 1929–2013).

Negative supply shocks cause inflation and unemployment. This makes for difficult policy choices for Federal Reserve Chairman Janet Yellen because any policy that alleviates one problem worsens the other.

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It’s a trade-off with no good answer. In the end, the United States and other economically advanced nations suffering from the supply shocks of the 1970s eventually chose to stabilize prices even at the cost of higher unemployment. But being an economic policy maker in the 1970s, or in early 2008, meant facing even harder choices than usual.