205 Viewpoints on Government Policy
Learning Objectives
- Summarize the neoclassical views on the effectiveness of fiscal and monetary policy
- Summarize the Keynesian views on the effectiveness of fiscal and monetary policy, including the importance of the expenditure multiplier
Reviewing the Neoclassical Perspective
Neoclassical economics covers several distinct schools of thought, including traditional neoclassical economics, supply side economics, and new classical economics. Each of these schools of thought shares a number of key beliefs, which makes them neoclassical. The first belief is that the macro economy is self-correcting, or that there is no need for government intervention. The second belief, for reasons to be discussed shortly, is that government “fine tuning” of the economy either through fiscal or monetary policy would be unwise and ineffective.
In general, neoclassical economists favor low taxes to stimulate aggregate supply and economic growth. They also favor limited government spending–they believe in spending on national defense, but not much for transfer policies like Social Security, Medicare, Medicaid or other types of welfare spending. Neoclassicals also favor a more passive monetary policy than Keynesians.
President Reagan advocated tax cuts in 1981 on the basis of their supply-side effects. Coupled with increased defense spending in the early 1980s, fiscal policy under Mr. Reagan clearly stimulated aggregate demand by increasing both consumption and investment. Falling inflation and accelerated growth were signs that supply-side factors may also have been at work during that period. President George W. Bush’s chief economic adviser, N. Gregory Mankiw, argued that the Bush tax cuts would encourage economic growth, a supply-side argument. Mr. Bush’s next chief economic adviser, Ben Bernanke, who became the next chairman of the Federal Reserve Board in 2006, made a similar argument and urged that the Bush tax cuts be made permanent.
Reviewing the Keynesian Perspective
Keynesians believe, based on the experience of the Great Depression of the 1930s and more recently, the Great Recession of 2007-2009, that the economy can be in equilibrium at a level of GDP that does not correspond to potential, so that a GDP gap exists. This means that the economy will not be at full employment. Such an equilibrium can correspond to either a recession or an inflationary boom. In addition, even if the economy is self-correcting, the process can be so slow that the GDP will not close, and employment will not be full for an extended period of time.
Because of this belief that either the economy is not self-correcting, or that the correction may take a long period of time, Keynesians also believe that government has a responsibility to manage the economy. They encourage stimulating the economy during recessionary times and slowing the economy down during booms, using a combination of fiscal and monetary policy. Let’s consider how this might w