Question

Which of the following policy recommendations are consistent with the classical, Keynesian, monetarist, and/or Great Moderation consensus views of the macroeconomy? a. Since the long-run growth of GDP is \(2 \%\), the money supply should grow at \(2 \%\) b. Decrease government spending in order to decrease inflationary pressure. c. Increase the money supply in order to alleviate a recessionary gap. d. Always maintain a balanced budget. e. Decrease the budget deficit as a percent of GDP when facing a recessionary gap.

Short answer

A) Growing the money supply at a rate equal to the long-run GDP growth (2%) B) Decreasing government spending to reduce inflationary pressure C) Increasing the money supply to alleviate a recessionary gap D) Maintaining a balanced budget E) Decreasing the budget deficit as a percent of GDP when facing a recessionary gap Answer: B) Decreasing government spending to reduce inflationary pressure and D) Maintaining a balanced budget

Step-by-step solution

Understand the macroeconomic theories

To determine which policy recommendations align with each of the macroeconomic views, we first need to know the basic ideas and principles behind them: 1. Classical: This view is based on the idea that the economy is self-regulating, and that government intervention is not necessary, since market forces will ensure long-term growth and full employment. The classical view also emphasizes the importance of maintaining a balanced budget and low inflation. 2. Keynesian: Keynes believed that government intervention is necessary to maintain full employment and economic growth, especially during recessions. In this view, fiscal policy (changes in government spending and taxation) plays an important role to stimulate aggregate demand. 3. Monetarist: Monetarists argue that controlling the money supply is the most effective way to stabilize the economy. According to them, maintaining a steady and predictable growth rate of the money supply is key to controlling inflation. 4. Great Moderation consensus: This view emerged in the late 20th century after a period of relatively stable economic growth and low inflation. It combines elements of both Keynesian and monetarist theories, believing that central banks should focus on inflation targeting and maintaining financial stability, while allowing for some government intervention in the form of fiscal policy.

Categorize the policy recommendations#a)

The policy to grow money supply at a rate equal to the long-run GDP growth (2%) is in line with the monetarist view, as they argue that a steady and predictable growth rate of the money supply is necessary to maintain economic stability.

Categorize the policy recommendations#b)

Decreasing government spending in order to decrease inflationary pressure is consistent with the classical view, which emphasizes maintaining low inflation and minimal government intervention in the economy.

Categorize the policy recommendations#c)

Increasing the money supply to alleviate a recessionary gap is in line with the monetarist view, which believes that controlling the money supply is the key to stabilizing the economy.

Categorize the policy recommendations#d)

Maintaining a balanced budget is consistent with the classical view, which advocates avoiding government deficits and market distortions caused by fiscal policies.

Categorize the policy recommendations#e)

Decreasing the budget deficit as a percent of GDP when facing a recessionary gap is more in line with the Great Moderation consensus view, which combines elements of both Keynesian and monetarist theories and accepts some degree of government intervention through fiscal policy, while maintaining a focus on controlling inflation in the long run.

Key concepts

Classical Economics

Classical economics is an economic theory that posits the economy as a self-regulating entity. It's like believing that with minimal interference, the market can fix itself. This school of thought suggests that the forces of supply and demand will naturally lead the economy toward full employment and long-term growth. An important aspect of this theory is maintaining a balanced budget, meaning not spending more than what is earned. The classical economists advocate for minimal government intervention, believing that such actions can sometimes create more harm than good.

Classical economists also emphasize keeping inflation low. This is achieved by avoiding unnecessary government expenditure, which can lead to inflationary pressures. Thus, recommendations such as maintaining low government spending to curb inflation reflect classical economic principles. Classicists believe in a predictable economic outlook where market cycles are part of a natural economic wave.

Keynesian Economics

Keynesian economics, named after John Maynard Keynes, argues that active government intervention is required to achieve economic stability and growth. According to Keynesians, during economic downturns, private sector demand often falls short, and it's up to the government to fill this gap with increased spending.

This approach involves manipulating fiscal policy, which includes adjustments in government spending levels and tax rates. For example, in the face of a recession, Keynesians would be more supportive of increasing government expenditure to stimulate aggregate demand, thereby reducing unemployment levels and closing any recessionary gaps.

The idea here is that the government should step in to "prime the pump," encouraging economic activity when the private sector cannot do so on its own. Importantly, unlike classical economics, Keynesian theory is more forgiving of budget deficits, especially during economic downturns.

Monetarism

Monetarism is an economic theory advocating for the control of the money supply as the primary means of managing an economy. Monetarists, led by economist Milton Friedman, stress the crucial role that government regulation of the money supply plays in controlling inflation.

Monetarism posits that if the money supply grows too quickly, inflation will ensue. Conversely, if the money supply is too restrictive, it could trigger a recession. Therefore, monetarists believe in a steady, predictable increase in the money supply, keeping in line with the potential growth rate of the economy.

Monetary policy, rather than fiscal policy, is considered the main tool for stabilizing the economy. For instance, in managing a recessionary gap, monetarists would suggest increasing the money supply as a remedy, ensuring a balanced and stable economic growth. The focus is on long-term financial stability rather than short-term fiscal measures.

Great Moderation Consensus

The Great Moderation consensus is a more recent approach combining aspects of both Keynesian economics and monetarism. It is based on the observation of reduced volatility in economic growth and inflation since the mid-1980s.

This consensus underscores the importance of central banks focusing on inflation targeting and ensuring financial stability while allowing some level of government intervention when necessary. The idea is for monetary policy to maintain stable price levels, with fiscal policy coming into play occasionally to manage the overall economy's needs.

During periods of economic downturns or inflationary pressures, the balanced approach of the Great Moderation allows for a controlled and guided intervention to achieve long-term economic stability. One policy that aligns with this view is reducing budget deficits as a percentage of GDP during times of recession, blending elements of fiscal responsibility with strategic interventions.