Chapter 15

After reading Chapter 15, STABILIZATION, you should be able to:
Describe the case for ACTIVIST POLICY.
Discuss FISCAL and MONETARY POLICY and tell how each can be used to stabilize the economy.
Tell how nonactivists counter the case for activist policy.
Understand the REAL BUSINESS CYCLE objection to activist policy.
Relate why nonactivists believe the major causes of the Great Depression were government policies and
list other reasons about why activist policy should not be used.
Describe why Keynesian economists contend that activist policy should be used to limit the GDP GAP.
FISCAL POLICY is changes in government spending or taxes designed to achieve
macroeconomic goals. MONETARY POLICY is changes in the money supply or credit
conditions designed to achieve macroeconomic goals.
1. Macroeconomic goals include full employment, price stability, steady economic growth, and
limiting the business cycle.
POLICY ACTIVISM is the use of fiscal and monetary policy to smooth fluctuations in the
business cycle. DISCRETIONARY POLICY means policymakers adjust policies according to
their beliefs about what is currently the best policy.
When the equilibrium level of output is less than the natural rate, as shown above, a
DEFLATIONARY GAP exists. In the figure, the equilibrium level of output, Y, is less than the
natural level of output, Yn.
1. A deflationary gap calls for an EXPANSIONARY FISCAL POLICY, such as an increase in
government spending or reduction in taxes, or an expansionary monetary policy. Such an
expansionary policy shifts the AD curve to the right and increases the equilibrium level of real
When the equilibrium level of output is greater than the natural rate, an INFLATIONARY GAP
exists. This is illustrated above, where the equilibrium level of output, Y, exceeds the natural level
of output, Yn.
1. When the economy experiences an inflationary gap, a CONTRACTIONARY FISCAL
POLICY, such as a decrease in government spending or increase in taxes, or a contractionary
monetary policy is appropriate. These policies shift the AD curve to the left.
AUTOMATIC STABILIZERS are government programs, such as the tax system, welfare
payments, and unemployment insurance, that help limit business cycle fluctuations without
requiring any additional action by the government. These programs limit the fall in income during a
recession and thereby moderate the recession.
An expansionary fiscal policy consists of increasing government spending and/or decreasing tax
rates. A contractionary fiscal policy takes the reverse actions.
Increasing the money supply is an expansionary monetary policy.
1. When the money supply increases, the interest rate falls.
2. The decrease in the interest rate raises investment.
3. When investment rises, the aggregate demand curve shifts to the right.
Monetary policy is the most flexible policy instrument; most fiscal policies take the form of
changes in taxes.
NONACTIVISM means that no government policy is pursued to smooth the fluctuations of the
business cycle; instead, the economy's self-correcting mechanism is relied upon to drive the
economy back to the natural level of output.
Nonactivists argue that activist policies are, at best, ineffective and, at worst, the primary cause of
business cycles. Rather than discretionary policy, nonactivists suggest the government follow two
fixed rules.
1. The money supply should grow at a constant rate every year. The rate should approximate the
long-run growth rate of real GDP.
2. The federal budget should be balanced over the business cycle. Surpluses in the recovery phase
should equal deficits in the recession phase.
Nonactivists make several arguments for their position:
1. They think the self-correcting mechanism works quickly so that it should be left to work
unaided by government policies.
2. They claim that the economy is naturally stable and that activist policies have been a major
cause of business cycles. According to this view, inappropriate monetary and fiscal policies
were the cause of the Great Depression.
3. They point out that it is difficult to devise proper activist policies, because economists do not
possess enough information about how the economy operates. Monetary policy may work after
long and variable lags.
4. The rational expectations school asserts that predictable activist counter-cyclical policies have
no effect on output.
5. Real business cycle theorists argue that business cycles are caused by shocks to aggregate
supply that cannot be controlled by monetary or fiscal policy.
Keynesian economists believe activist policy is desirable because they contend that the
self-correcting mechanism takes too long to work because of wage and price inflexibilities.
The GDP GAP is the difference between actual output and full employment output. Keynesian
economists suggest the government use activist policies to eliminate the GDP gap.
Activist policies have been pursued since at least the mid-1960s. As evidence in favor of activism,
Keynesian economists use the observation that business cycles have moderated since the advent of
activist policies.
True or False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
____ 1.
Economists are in general agreement that the government should conduct activist fiscal and
monetary policies.
____ 2.
A goal of activist policy is to increase employment during a recession.
____ 3.
Nonactivists contend that the Great Depression was the result of ill-advised government
____ 4.
Keynesian economists believe the government should conduct activist policies.
____ 5.
Nonactivists believe that the private sector is prone to large fluctuations and needs government
policies to provide stability.
____ 6.
The growth rate of GDP has been less variable after World War II.
____ 7.
There is general agreement among economists that the self-correcting mechanism works.
____ 8.
Some economists believe that the 25 percent fall in the money supply from 1929 to 1933 was a
cause of the Great Depression.
____ 9.
Rational-expectations economists argue that predictable policies have the greatest effect on
output and employment.
____ 10. Nonactivist economists suggest that the money supply should grow at a constant rate each year
without regard to the prevailing economic conditions.
____ 11. There is general agreement among economists that the economy tends to return to the natural
rate of unemployment.
____ 12. The GDP gap is the difference between actual GDP and full employment GDP.
____ 13. If actual GDP exceeds the natural level of GDP, a deflationary gap exists.
Multiple Choice
Circle the letter corresponding to the correct answer.
Which school of thought believes the self-correcting mechanism works slowly?
a. Keynesian
b. Monetarist
c. Rational expectations
d. Keynesian and monetarist only
e. All schools believe the self-correcting mechanism is slow.
Nonactivists believe that
a. the private sector is not stable.
b. it is easy to conduct correct activist policy.
c. government policy is necessary to stabilize the economy.
d. activist policies are the reason why business cycles have been milder after World War II.
e. activist policies may destabilize the economy.
There is currently general agreement about which of the following?
a. The government should not use activist policies.
b. The economy eventually returns to the natural rate of unemployment.
c. The Great Depression is proof that activist policies are desirable.
d. The self-correcting mechanism works rapidly.
e. Running government policy according to rules is better than trying to use discretionary policy.
Monetarists contend that a cause of the Great Depression was
a. the doubling of reserve requirements by the Fed in 1937.
b. the large tax increases passed in 1932 and 1937.
c. New Deal policies that raised the monopoly power of firms and unions.
d. the Fed allowing the money supply to fall by 25 percent between 1929 and 1933.
e. All of the above
In part, Keynesian economists base their claim that activism is beneficial on
a. the difficulty of devising activist policies.
b. the rational expectations view that anticipated policies may have no effect on output.
c. the ease with which government spending may be used for activist purposes.
d. the milder business cycles experienced after World War II.
e. the historical record of performance during the Great Depression.
6. Real business cycle theorists argue that business cycles are
a. not real, simply a statistical illusion.
b. caused by fluctuations in real aggregate demand.
c. caused by unemployment and inflation together.
d. caused by fluctuations in aggregate supply.
e. All of the above
Essay Questions
Write a short essay answering each question.
1. "Activist policies have been followed by the government only after World War II. The business cycles
since that time have been much milder than those before the war. Therefore, activist policies have
successfully stabilized the economy." How would an economist favoring nonactivism respond to this
2. Why is it important for society to determine whether the activist or nonactivist beliefs are correct?
3. What role does the self-correcting mechanism play in the debate between activists and nonactivists?
4. What did Keynes mean with his comment that "In the long run, we are all dead'?
5. Summarize the reasons why both rational expectations economists and real business cycle theorists
opposes activist policy.
True or False
The question whether the government should follow activist policies is one of the major
disagreements among economists.
A recession occurs when there is a deflationary gap so that the actual level of GDP is less than
its natural level, which means that the unemployment rate exceeds the natural rate.
Keynesian economists assert that the Great Depression was the result of instability in the
private sector and, as such, is evidence of the desirability of activist policies; nonactivists
disagree by tracing blame for the Depression to government policies.
Monetarist and rational-expectations are nonactivist economists, and they disagree with the
Keynesian belief that discretionary policy is desirable.
Monetarists believe the private sector is stable and that most of the economy's instability is the
result of poor government policies.
Keynesian economists view this as evidence in favor of activism.
While economists agree that the self-correcting mechanism works, there is disagreement over
its speed.
This is one of the government policies that monetarists hold responsible for the Great
Rational-expectations economists claim that predictable policies have no effect on output or
10. To minimize inflation, nonactivists suggest that the money supply's growth should be near the
long-run growth rate of real GDP.
11. This reflects the fact that most economists believe that the self-correcting mechanism
eventually restores the economy to its long-run equilibrium.
12. This is the definition of the GDP gap.
13. When actual GDP exceeds the natural level of GDP, there is an inflationary gap and not a
deflationary gap.
Multiple Choice
1. a.
Because Keynesians think the self-correcting mechanism is slow, they argue that the government
should conduct activist policies designed to move the economy more rapidly to its natural level of
2. e.
Indeed, nonactivists contend that activist policy worsens business cycle fluctuations.
3. b.
While economists generally agree that the economy returns to the natural rate of unemployment
and GDP, the key question is the speed of the return. Activists contend that the economy's return is
slow, while nonactivists tend to suggest that the economy returns quickly.
4. e.
Monetarists think that all these (inappropriate!) policies helped create the Great Depression.
5. d.
Keynesians believe that business cycles have been less variable because of the government's
activist policies.
6. d.
Real business cycles theorists say that business cycles are caused by shocks to supply.
Essay Questions
1. Economists favoring nonactivism dispute this statement. They claim that the milder business cycles are
the result of more steady growth in the money supply. In fact, they assert that business cycles would be
even less variable if the government stopped following any sort of activist policy.
2. It is important to determine which view is correct because following the wrong view harms society. If
the Keynesian (activist) view is right, the GDP gap measures the gain to society if activist policies
designed to eliminate the gap are followed. If the monetarist or rational expectations (nonactivist) view
is correct, the GDP gap again can measure, in part, the harm inflicted on society by following the wrong
view. Nonactivists believe that most of the fluctuations in GDP, the GDP gap, are caused by the
government's use of activist policies.
3. The speed with which the self-correcting mechanism takes to return the economy to its natural rate of
output plays an important part in the activist/nonactivist debate. Economists who favor activist policies
believe the self-correcting mechanism is slow. Thus, there are large potential gains to society if the
government, by using activist policies, helps speed up the process through which the economy returns to
its long-run equilibrium. (These gains are especially large if the unemployment rate is above the natural
rate so that activist policies can help lower it rapidly to its long-run equilibrium.) Nonactivists generally
think that the self-correcting mechanism is reasonably fast. As a result, the potential gains from activist
policies are small.
4. Keynes's comment was an expression of his contention that the self-correcting mechanism worked
slowly. Keynes, like almost all economists, believed that the self-correcting mechanism will restore the
economy to the natural level of output. However, Keynes, viewing the situation in the 1930s when the
unemployment rate seemed to be permanently stuck at excessively high levels, concluded that the selfcorrecting mechanism was exceedingly slow. Hence, when others suggested that the government should
do nothing because in the long run the self-correcting mechanism would restore the economy to its
natural rate of output, Keynes commented that by the time the long run finally was reached, we would
all be dead.
5. Rational expectations theorists say that activist policy is too unpredictable. If people anticipate the
policy effects, there will be no effect on real variables such as real GDP and unemployment. Only if
people are fooled by the policy will it be effective. Real business cycle theorists argue that business
cycles are caused by technology shocks that shift aggregate supply. We cannot use demand-oriented
policies to correct supply shocks.