Economics Homework Help

Please respond to the following prompts in a post with a minimum of 150 words, then comment on other post(s).  Comment on other post is optional.

• In this course we learned about a number of real world complications that make monetary and fiscal policy more challenging than simple theory would suggest. Given the state of the economy and the causes of that state—think back to earlier discussions about the current economy—what should be the appropriate mix of fiscal and monetary policy, from a Keynesian perspective? From a neoclassical perspective?
• Which makes the most sense to you?
• What was the most interesting topic or subject we have covered in this semester?

Why It Matters: Policy Applications

Why apply fiscal and monetary policies in macroeconomic situations?

Figure 1. It’s finally time to apply the concepts you’ve learned about fiscal and monetary policy.

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, in 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?
• How is macroeconomic policy is the real world more complicated than in theory?

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, if anything, should be done about that?

Introduction to Keynesian and Neoclassical Policy Prescriptions

What you’ll learn to do: compare viewpoints on government spending and taxes between the Keynesian and Neoclassical perspectives

In previous modules, we’ve learned about both the Keynesian and Neoclassical perspectives on the macro economy. Neoclassicals take a laissez-faire approach to macro policy. They believe that the economy is self-correcting, and doesn’t need government intervention. Indeed, we will see that Neoclassicals believe that government intervention is counterproductive. Keynesians take a more active approach. They believe that the economy takes too long to correct itself and that government has a responsibility to speed things up and minimize the adverse effects of unemployment, inflation and other economic problems.

In this section, we will drill down into the two perspectives to develop a more nuanced understanding of their strengths and weaknesses. In the process, we will create a stronger understanding of both the power and the limits of fiscal and monetary policy.

Introduction to New Classical Economics

What you’ll learn to do: describe the basic tenets of new classical economics

Many contemporary macroeconomic models use rational expectations and Ricardian Equivalence theories in their predictions of future economic trends.

New Classical Economics is a neoclassical perspective that makes a stronger case for the ineffectiveness of fiscal & monetary policy to stabilize the economy. This case is based on two beliefs that are unique to New Classical Economics: the theories of rational expectations and Ricardian Equivalence.

Introduction to Macro Policy Options in the Real World

What you’ll learn to do: identify appropriate macro policy options in response to the state of the economy

Neither fiscal nor monetary policies are as mechanical and surgical effectively as we learned about in earlier modules. Fiscal policy is subject to crowding out, but crowding out only reduces the effectiveness of fiscal policy and doesn’t eliminate it. Monetary policy may be better at slowing an economy down than stimulating it. Expectations clearly matter to economic decision making and economic policy, but do real world actors have Ricardian equivalence and rational expectations? Most economists would say no. Where does that leave us? Read on to learn more about the real-world applications of these policies.

WATCH IT

Watch this video to review some of the concerns of fiscal policy, including the crowding out effect and the policy lags mentioned above.

 

You can view the transcript for “(Macro) Episode 27: Crowding & Lags” here (opens in new window).

Policy Imprecision

Fiscal and monetary policies don’t always work out as planned because the tools are of varying precision. The Fed can increase the amount of reserves in the banking system, but it can’t guarantee that banks convert all their excess reserves to loans. Similarly, whenever depositors remove cash from their accounts, the money multiplier falls. Even when interest rates fall the amount the Fed wishes, that doesn’t guarantee households and businesses will increase their borrowing as much as the Fed hopes, which means that aggregate demand will not increase according to plan. Thus, for any given monetary policy action, the extent to which it has full effect depends on the responses of banks, depositors, and borrowers. These the Fed cannot control.

The effect of tax cuts depends on what households and businesses do with the money they get back from taxes. Demand management policies depend on households increasing consumption expenditures and businesses increasing investment expenditures. Any given tax cut may bring about more or less additional spending. Additional government spending is perhaps the most precise form of stimulus–if the Congress increases spending by $100 billion, then aggregate demand increases by that much. But even in the case, the exact level of fiscal policy that the government should implement is never completely clear. Should it increase the budget deficit by 0.5% of GDP? By 1% of GDP? By 2% of GDP? In an AD/AS diagram, it is straightforward to sketch an aggregate demand curve shifting to the potential GDP level of output. In the real world, we only know roughly, not precisely, the actual level of potential output, and exactly how a spending cut or tax increase will affect aggregate demand is always somewhat controversial. Also unknown is the state of the economy at any point in time. When the Great Recession began to play out, during the early days of the Obama administration, no one at the time knew the true extent of the economy’s output gap. For all these reasons, discretionary fiscal and monetary policy is as much an art as a science.

Temporary and Permanent Fiscal Policy

An additional complication to policy effectiveness is whether the policy is explicitly temporary or permanent. A temporary tax cut or spending increase will explicitly last only for a year or two, and then revert back to its original level. A permanent tax cut or spending increase is expected to stay in place for the foreseeable future. The effect of temporary and permanent fiscal policies on aggregate demand can be very different. Consider how you would react if the government announced a tax cut that would last one year and then be repealed, in comparison with how you would react if the government announced a permanent tax cut. Most people and firms will react more strongly to a permanent policy change than a temporary one.

This fact creates an unavoidable difficulty for countercyclical fiscal policy. The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession, and then a contractionary fiscal policy with budget surpluses when the economy is growing well. But if both policies are explicitly temporary ones, they will have a less powerful effect than a permanent policy.