No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eighteen: The “macro” view of the economy 446 INTRODUCTION Since its origins in the aftermath of the Great Depression and the publication of J.M. Keynes’ The General Theory of Employment, Interest and Money , macroeconomics has claimed two essential functions: that of the scientist and that of the policy advisor (or engineer). As a scientist, the macroeconomist wants to understand what every scientist is essentially trying to do: the causal relationships (cause and effect) of items of interest. In this case, the relationships are between macroeconomic variables. Yet the scientist has another hat—trying to use knowledge of those relationships to guide economic policymakers. Notice that there are underlying assumptions in this statement. First is that we ought to have someone improving the economy, and second, that any policymaker is likely to improve on a suboptimal economy. The era preceding the Great Depression was characterized by classical liberalism and basically a laissez faire attitude toward markets. With government taking a hands-off approach to market activities, the depth of the stagnation in the Great Depression created an environment where people were more willing to accept government intervention. After all, with 25% unemployment, is it likely that the government could do worse? Or so the thinking goes. In this chapter, we will see how the government tries to guide economic policy and explore some of the key economic variables that are often studied. Let’s first review some macroeconomic terminology. The government has two primary means of affecting the economy. Fiscal policy consists of the taxing and spending decisions of the government. Monetary policy consists of managing the flow of money and credit in an economy (usually by targeting some interest rate) to primarily affect the private sector’s consumption and investment decisions. Fiscal policy decisions can affect either the public sector (through direct government spending) or the private sector (through taxes). Likewise, monetary policy primarily targets the private sector’s saving and investment decisions, although controlling interest rates also affects government spending decisions to the extent that governments fund some spending through debt issuance in addition to taxes (the usual practice). So if an economy is booming and inflation is perceived to be a potential problem, a policy maker might want to slow the economy down through tight fiscal policy, by either raising taxes on the private sector or reducing government expenditure. Or the monetary authority might restrict the flow of money and credit by increasing interest rates. The reverse would be true for a slow economy: policy makers might reduce taxes and/or increase government spending on the fiscal side, or they might increase the flow of money and credit into the economy on the monetary side. So the underlying toolbox of macroeconomic stabilization is government policy, and its tools are fiscal or monetary policy. To understand whether this is a good thing or not, let’s first review (from chapter 14) an economic rationale for government at all. In today’s world there are many people who think collective action via the government is the best way to operate based on their own personal preferences. Others go to the opposite extreme, thinking that anarchy is the best solution, since, in their view, only peaceful cooperation can lead to socially Fiscal policy: the taxing and spending decisions of the government Monetary policy: managing the flow of money and credit in an economy (usually by targeting some interest rate) to primarily affect the private sector’s consumption and investment decisions