Capitalist economics experience business cycles. Over the past 50 or so years go

Question

Capitalist economics experience business cycles. Over the past 50 or so years governments have been able to moderate these business cycles and keep price instability and unemployment at a minimum relative to the 1800s and early 1900s. There are two policy methods that the government can use: fiscal (Treasury Dept. and Congress) and monetary (Federal Reserve). How do these two policy methods work, what are the differences between them, what does the concept of scarcity or lack thereof have to do with the effectiveness of each and which one is more effective at controlling price instability and unemployment? Your answer should include why there is a need for government intervention in the first place (i.e. if the markets are self-correcting in reality there should be no need for government help), the process of both policies (meaning what steps are involved if any and how money gets into the hands of consumers and firms) and the theories behind them (demand-driven economy or supply-driven economy).

Explanation / Answer

Classical believed in the free play of the market forces and Say's Law and emphasized on no government intervention. But this school of thought could not explain the Great Depression of 1929 - 33. Thus, Keynesian school of thought was born which emphasized on government intervention mainly through fiscal policy to help the economy come out of depression. Monetarists led by Friedman emphasized on Monetary policy. The modern day economists emphasize on both monetary and fiscal policy to achieve equilibrium in the economy.

Fiscal policy involves government changing tax rates and level of government spending to influence aggregate demand in the economy. In a recession government follows, expansionary fiscal policy by reducing tax rates and raising the level of government spending to shift Aggregate demand to the right. In a boom, the government follows contractionary fiscal policy by reducing the level of government spending and raising the taxes. This shift the AD curve to the left and controls boom.

Monetary policy is carried out by the Central Bank and involved setting the base rate influencing the money supply. If inflation is going above target, then they increase the interest rates by reducing the money supply in the economy. This will raise interest rates which will lead to decline in the investment. Thus, AD declines and inflation can be controlled. If the economy went into recession, the Central Bank will cut interest rates.

In controlling the price stability in the economy, Monetary policy is more effective as pointed out in above paragraph that the Central Bank of the countries set a targeted rate of interest and influence money supply accordingly.

To control unemployment, fiscal policy is more effective as increase in aggregate demand in the economy will lead to more workers being hired to meet the demand and increase supply and thus unemployment will decline as economy will move towards full employment.

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