Chapter 36: Six Debates over
1. Should monetary and fiscal policymakers try to
stabilize the economy?
2. Should the government fight recessions with
spending hikes or tax cuts?
3. Should monetary policy be made by rule rather than
4. Should the central bank aim for zero inflation?
5. Should the government balance its budget?
6. Should the tax laws be reformed to encourage
1. Should monetary and fiscal policymakers
try to stabilize the economy?
• Changes in aggregate demand and aggregate supply
can lead to short-run fluctuations in production and
• Monetary and fiscal policy can shift aggregate
demand, and thereby, influence these fluctuations.
• But even if policymakers can influence short-run
economic fluctuations, does that mean they should?
Pro: policymakers should try to stabilize the
When households and firms become pessimistic, for
instance, they cut back on spending, and this reduces
the AD for goods and services.
This fall in AD, in turn, reduces the production of
goods and services.
Firms lay off workers, and the unemployment rises.
Real GDP and other measures of income fall.
• Thus, when aggregate demand is inadequate to ensure
full employment, policymakers should boost
government spending, cut taxes, and expand the
• When aggregate demand is excessive, risking
high inflation, policymakers should cut
government spending, raise taxes, and reduce
the money supply.
• Such policy actions put macroeconomic theory
to its best use by leading to a more stable
economy, which benefits everyone.
Con: policymakers should not try to stabilize the
Monetary and fiscal policy can be used to stabilize the
economy in theory, but there are substantial obstacles to
the use of such policies in practice.
One problem is that monetary and fiscal policy do not
affect the economy immediately but instead work with a
Monetary policy affects AD primarily by changing
interest rates, which in turn affect spending. But many
households and firms set their spending plans in advance.
Many studies indicate that changes in monetary policy
have little effect on AD until about six months after the
change is made.
Fiscal policy works with a lag because of the long
political process that governs changes in spending and
When policymakers change monetary or fiscal policy,
they must rely on educated guesses about future
economic conditions, and yet economic forecasting is
• Too often, policymakers trying to stabilize the
economy do just the opposite.
• Economic conditions can easily change between the
time a policy action begins and the time it takes effect.
• Because of this, policymakers can exacerbate rather
than mitigate the magnitude of economic fluctuations.
2. Should the government fight recessions with spending
hikes rather than tax cuts?
– When president George W. Bush became president in
2001, the economy was slipping into a recession.
– He responded by cutting tax rates.
– When president Barack Obama became president in
2009, the economy was again in recession, the worst
recession in many decades.
– He responded with stimulus package that offered some
tax reductions and substantial increases in government
– Which instrument of fiscal policy-government
spending or tax cut-is better for reducing the severity
of economic downturns?
Pro: the government should fight recessions
with spending hikes
• Since Keynes, economists have understood that
the fundamental problem during recessions is
inadequate aggregate demand.
• When firms are unable to sell a sufficient
quantity of goods and services, they reduce
production and employment.
• The key to ending recessions is to restore
aggregate demand to a level consistent with full
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