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The Case for Government Intervention

Because Keynes did not believe that a market economy could be relied on to automatically preserve full employment and avoid inflation, he argued that the central government must manage the level of aggregate demand to achieve those objectives. How could this be accomplished? One approach was through fiscal policy—the manipulation of government spending and taxation in order to guide the economy's performance. When unemployment exists, the federal government should increase its spending on goods and services (without increasing taxes). This will shift the aggregate demand curve to the right and increase the equilibrium level of real GDP and employment. A reduction in income taxes (without a reduction in government spending) will accomplish the same thing because it will cause households to spend more at any given price level. When inflation exists, government spending should be reduced or taxes increased. These policies will reduce aggregate demand and thus reduce inflationary pressures.

Another approach would be to use monetary policy: policy intended to alter the supply of money in order to influence the level of economic activity. When unemployment exists, the Federal Reserve—the governmental agency that regulates the money supply—should increase the amount of money in circulation so that households and businesses will find it easier to borrow funds. This will tend to increase spending for goods and services, which will shift the AD curve to the right and raise the level of equilibrium output and employment. Inflation calls for a reduction in the money supply. By making it more difficult to borrow funds, the Federal Reserve can reduce spending and thereby combat inflation.

The 1990s: The Debate Continues

Keynesian theory held sway through the 1960s, and many economists remain Keynesians today. But Keynesian thinking began to lose influence in the 1970s, when the Keynesian model seemed unable to explain the stagflation— simultaneous unemployment and inflation—that characterized that period. Since then, Keynesians have been rethinking and modifying their views, and new schools of thought have emerged to challenge their position.

Interestingly, some of these challengers—monetarists and rational expectations theorists—bear a striking resemblance to the classical economists of old. In particular, they generally argue that the economy tends toward full employment and that government intervention is unnecessary and even counterproductive. Thus, the debate about economic policy has come full circle. Economists are once again arguing about the proper role of government in economic policy: Should government actively attempt to stabilize the economy to prevent unemployment or inflation, or should its position be hands off? We will consider the current activist-nonactivist debate in detail in Chapter 14.

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