ABSTRACT

The practical prescription of the Keynesian revolution can be stated simply. Use counter-cyclical fiscal policy as well as monetary policy to raise aggregate demand to combat a recession: temporarily increase cash transfers or government purchases of goods and services, or temporarily cut taxes, until a strong recovery has been engineered; complement this fiscal policy with a monetary policy that cuts interest rates, but do not rely on monetary policy alone to counter a recession. The government’s announced commitment to use fiscal as well as monetary stimulus in a recession would help induce the private sector to maintain its spending at the onset of a recession. If the economy is hit with a negative demand shock that throws it into a recession, will households and business managers expect the economy to recover, or will they expect the recession to deepen or drag on? If they expect the government to act aggressively and effectively using both fiscal and monetary policy, they will continue to spend, and this behavior will sustain aggregate demand, and in itself help generate a recovery. On the other hand, if they expect the government to rely solely on monetary policy, and they observe that interest rates are already low, they may grow pessimistic, cut their spending, and thereby deepen or prolong the recession.