Reconsider the problem opened at the top of the chapter: The economy is in a recession. The mood is somber. Your president will be up for re-election next year. Based on your economic knowledge and past experiences, what would you advise?
1) The making of economic policy is the sixth and last of our macroeconomic issues. The question is whether the government can effectively intervene in the economy to combat the five problems discussed in the previous chapters, and if so how it should do so.
2) According to the model of rational economic policy-making, policy makers accept the ultimate goals as voted on by the electorate, choose appropriate policy instruments to hit the intermediate targets which give the best guarantee of achieving the best mix of ultimate goals. Economic theory is a crucial ingredient.
3) The public choice approach stresses, on the contrary, the self-interest of policy makers and recommends constitutional constraints on their actions (such as the constraint that the federal budget has to be balanced).
4) Fiscal, monetary, and institutional policies are the three main types of policies the government can choose from. Each of them implies a different set of policy instruments.
5) The effectiveness of policies is determined by the extent to which they succeed in achieving the desired mix of ultimate goals. Keynesian economists have generally more faith in the effectiveness of government policies than monetarist and new classical economists. Keynesian economists will usually, though not always, advocate discretionary policies, that is, changes in expenditures, taxes, interest rates, or economic institutions in response to the day's problems. Monetarists and new classicals generally favor policy rules; they prefer policies that are predictable.
Crucial in these arguments is the way in which aggregate supply is supposed to respond to changes in fiscal and monetary variables. The more responsive is aggregate supply, the less effective is fiscal policy.
6) Experiences with various policies since 1960 produce mixed evidence for their effectiveness. Fiscal policies appeared to be effective to get the economy growing in the early 1960s but were unable to stop the economy from overheating.
A monetarist policy was effective in reducing in inflation in the early 1980s but proved to be an unreliable guide in the subsequent years. When the economy slid into another recession in 1990 the Federal Reserve worked the old Keynesian remedy by lowering interest rates.
The supply side policies of the early 1980s were targeted to stimulate work, savings and investments. The great beneficiary, however, seemed to have been consumption, and thus aggregate demand, in a paradoxically Keynesian way. Saving was low and investment below normal levels.
7) From time to time the U.S. government will try out institutional policies in an attempt to influence macroeconomic performance. The policies require changes in laws, such as price controls, support for export-oriented industries, or protection abroad.
8) The power of economic theory in guiding economic policy is limited but not completely absent. Economists can provide clear and thoughtful advice to politicians who are trying to muddle through. As Stein said, economists don't know it all, but know a little bit more than their clients.