The decision of what influences the economy is a tough one. Paul Haarman says some economists believe that the government should stimulate aggregate demand through fiscal policy, while others believe monetary policy is more effective. Congress has largely disagreed with these two schools of thought in America’s case, opting for a mix between monetary and fiscal factors for its economic plans. With this in mind, it seems inevitable that many countries worldwide will soon shift away from their current economic policies towards different combinations of these two types of policies.
Paul Haarman’s Explanation of Fiscal Policy
Fiscal policy involves government spending and tax cuts to help grow the economy. The push of budgetary policy occurs when a collapse of aggregate demand occurs, causing inflation. In contrast, fiscal policy pulls when aggregate demand is high, but the economy is not growing at a fast rate. According to Paul Haarman, this occurs during periods of economic growth. As a result, fiscal policy can maintain economic growth, deter dangerous inflation and spur an already booming economy.
Monetary policy involves the Federal Reserve changing interest rates to control the money supply. A reaction to this can occur due to the Fed’s decision to raise or lower interest rates. The push of monetary policy occurs when inflation is present, while the pull of monetary policy occurs when there is no aggregate demand growth or bad deflation occurs.
When inflation rises and GDP growth is strong, the Fed will implement higher interest rates.
This will cause a more significant money supply, increasing aggregate demand by increasing investment and consumption spending by consumers. This raises prices without hurting actual output since nominal GDP (GDP in dollars) has not fallen.
The Arguments for Fiscal Policy
The case for fiscal policy, while not the strongest, is one that has been most widely accepted in the past few decades because of its success during times of economic recession. For example, in February 1937, the Roosevelt administration passed the new deal to help combat a recession throughout the United States. In addition, the government also passed measures to increase spending and decreased taxes during World War II.
The case for monetary policy is much weaker since it looks at the economy from an aggregate demand perspective. The government does not typically provide any genuine assistance in stimulating aggregate demand.
Instead, the Fed focuses on price stability by lowering interest rates below market-clearing levels. This action decreases inflationary pressures in the economy by increasing savings and reducing spending. Which lowers prices without causing a real output contraction or loss of jobs. Also, as Paul Haarman points out, even if the Fed were to allow the economy to cool off completely, there is always a chance that the economy will fall into a dangerous deflationary trap.
One of the effective ways the government has used to increase economic growth and prevent inflation is by implementing fiscal policy. Fiscal policy can help stimulate economic growth promptly when aggregate demand is weak due to closing loopholes and overreacting. To achieve this, a fiscal policymaker must act quickly to correct aggregate demand imbalances during the early stages of an economic recovery.