Chapter 7
Fighting Recessions With
Monetary and Fiscal Policy
In this chapter, I go deep into how governments can use monetary and fiscal
policy to help keep economies out of recession. Basically, fiscal
policy is using government spending and taxes to stimulate the total demand
for goods and services by causing either the government, consumers, or firms
to spend more. Monetary policy also works to stimulate spending by using
changes in the supply of money to lower interest rates, the idea being that
lower interest rates will cause firms to borrow more for new projects in
addition to causing consumers to borrow more for spending on goods and
services.
In the book, I stick
closely to the orthodox Keynesian model of how fiscal and monetary policy
should work. This model is "demand side" because it is interested in
using government policy to stimulate the demand for goods and services.
For instance, if the economy is in recession and lots of workers are
unemployed and lots of factories are idle, one way to get out of it would be
to get consumers and the government to spend a whole lot more buying goods
and services. If they increase their demand enough, then all the idle
factories will be put back to work and all the unemployed people will be
rehired.
The heterodox
alternative is called "supply side economics" because it attempts to solve
the recession problem by using government policies to stimulate the desire
of firms to supply more. The idea is that if firms try to supply more,
they will end up using all the idle factories and rehire all the unemployed
workers. But how do you get firms to want to produce more when you are
in the middle of a recession? By increasing their incentives. In
particular, by lowering tax rates so that production becomes more
profitable.
A lot of people
object to the supply side strategy. There are two main reasons.
The first is that if you cut taxes in the middle of a recession, you run the
risk of increasing the government's budget deficit. The answer that
"supply siders" give to this conjecture is that if the tax cuts stimulate
the economy enough, then total tax revenues will likely increase. That
is, the government may be taking a smaller percentage, but with a growing
economy it will be a smaller percentage of a much larger economy---the
result being that the government's total tax collections will increase.
The second big objection has to do with fairness.
Many people don't like the idea of cutting taxes on firms during a recession
because it seems like a gift to firms at the same time that the government
isn't doing enough to help the unemployed. The response given by
supply siders is that the best thing the government could do for the
unemployed is to get them jobs. And if cutting taxes does that, then
it is the obviously correct thing for the government to do.
Here is a very detailed paper on supply side economics
by
Bruce Bartlett,
that details the development of supply side ideas during the 1970's as well
as how those ideas have fared during the last 30 years when put into
practice. You should read this article since supply side ideas are
very popular on Wall Street and are the only strong alternative to the
Keynesian orthodoxy. Most macroeconomic policy debates are clearly
drawn contests between Keynesians (demand siders) and supply siders.
If you're wondering why supply side ideas aren't
covered in the book, it's because most textbooks are very orthodox and I
didn't want to write anything that would confuse people who were reading
Economics for Dummies along side a textbook. For a shorter opinion
article piece that gets to the heart of the policy ideas advocated by supply
siders, read this piece by
Robert L. Bartley that appeared in the Wall
Street Journal's OpinionJournal.com. This short piece by
Bruce Bartlett also gets at the supply side
idea that lower marginal tax rates lead people to work, save, and invest
more.
