Macroeconomic Policy

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.” We explain the context in which he made this remark in the accompanying For Inquiring Minds.

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

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 monetary and 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 an active stabilization policy, which is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

!worldview! FOR INQUIRING MINDS: Keynes and the Long Run

The British economist Sir John Maynard Keynes (1883–1946), probably more than any other single economist, created the modern field of macroeconomics. We’ll look at his role, and the controversies that still swirl around some aspects of his thought, in a later chapter on macroeconomic events and ideas. But for now let’s just look at his most famous quote.

In 1923 Keynes published A Tract on Monetary Reform, a small book on the economic problems of Europe after World War I. In it he decried the tendency of many of his colleagues to focus on how things work out in the long run—as in the long-run macroeconomic equilibrium we have just analyzed—while ignoring the often very painful and possibly disastrous things that can happen along the way. Here’s a fuller version of the quote:

This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again.

Keynes focused the attention of economists of his day on the short run.

Can stabilization policy improve the economy’s performance? If we reexamine Figure 12-8, 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.