MAcro CHAPTER 5.1:

CHAPTER SUMMARY

This chapter is a review of how fiscal and monetary policy are used to correct a recessionary or inflationary gap.

Fiscal policy, government taxation and spending, is controlled by elected officials - the President and Congress. If there is a recessionary gap, they might increase spending or reduce taxation to increase aggregate demand. If there is an inflationary gap, they might decrease spending or increase taxation to reduce aggregate demand. These actions would aim to bring the short-run aggregate equilibrium back to the LRAS.

Monetary policy, changes in the money supply and interest rates, is controlled by unelected members of the Federal Reserve. If there is a recessionary gap, they might increase the money supply to increase aggregate demand. If there is an inflationary gap, they might decrease the money supply to reduce aggregate demand. These actions would aim to bring the short-run aggregate equilibrium back to the LRAS.

The reason we have an unelected group in charge of the money supply is because they need to be able to make these decisions with the long run in mind. Politicians often argue and disagree, and make decisions that are good in the short term, but not the long term, because they need to worry about winning their next election. By having economists who are not elected make decisions about the money supply, they can focus on what is best in the long run without worrying about being re-elected.

The government does also have the option of doing nothing at all. As we saw, over time, we expect changes in wages bring the economy back to the LRAS, but this may take a long time.

The chart below summarizes all the possible policy actions depending on economic conditions.

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