Which of the following monetary and fiscal policy mixes will reduce unemployment?

journal article

The American Economic Review

Vol. 76, No. 2, Papers and Proceedings of the Ninety-Eighth Annual Meeting of the American Economic Association (May, 1986)

, pp. 203-208 (6 pages)

Published By: American Economic Association

https://www.jstor.org/stable/1818765

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The American Economic Review is a general-interest economics journal. Established in 1911, the AER is among the nation's oldest and most respected scholarly journals in the economics profession and is celebrating over 100 years of publishing. The journal publishes 11 issues containing articles on a broad range of topics.

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What Is a Policy Mix?

A policy mix may be any combination of complementary fiscal and monetary policies that a country adopts to manage its economy or to respond to a particular economic crisis.

The policy mix is usually made up of contributions from the nation's central bank, such as the Federal Reserve in the U.S., and its federal government.

Key Takeaways

• A policy mix is a combination of measures enacted by both fiscal and monetary policymakers in order to strengthen or stabilize a nation's economy.
• Monetary policy is managed by a nation's central bank while the federal government is responsible for fiscal policy.
• Fiscal policy involves spending money and raising money. Monetary policy is the control of the money supply.
• Although governments and central banks have different goals and time horizons, they may work together to stimulate (or cool) economic growth.

How a Policy Mix Works

A country's economic policy consists of two components—its fiscal policy and its monetary policy.

• A nation's fiscal policy is made up of all of its programs that involve spending money and raising money. These programs exist in part to support crucial components of the economy such as employment, inflation, and demand for goods and services.
• The nation's monetary policy is imposed by its central bank, which controls the supply of money, primarily by controlling short-term interest rates.

In most democratic countries, elected federal legislatures control fiscal policy, while independent central banks handle monetary policy. In the U.S. this is the Federal Reserve (known as the Fed).

Governments and central banks generally share a broad set of goals. They include a low unemployment rate, stable prices, moderate interest rates, and healthy growth.

Fiscal and monetary policymakers employ different tools to accomplish these goals and often stress different priorities.

Governments are run by elected officials who must win popular approval from the general public at regular intervals, and that fact has an impact on the timing and the nature of the policies they act upon. Central bankers are technocrats who don't directly answer to voters. This gives them the ability to act independently.

Example of a Policy Mix

So how does this all work? In good times and bad, controlling inflation is a prime example of a problem with a policy mix solution.

Inflation occurs when prices rise and the purchasing power of a single unit of currency declines. This means that people buy fewer goods and services because their money doesn't stretch as far as it once did.

The problem spirals, leading to a drop in consumer and business spending. Some businesses cut back production in light of poor demand. Others put off plans to expand, waiting for better times. This leads to higher unemployment, among other effects.

A nation's federal government and central bank may step in to help curb inflation through a policy mix. For instance, the government may implement tax cuts to encourage consumers or businesses, or both, to spend more money.

At the same time, its central bank may reduce interest rates in order to encourage new investments by both consumers and businesses. The central bank may also increase the money supply, giving the banks an incentive to lend out more money.

The Great Recession

Broadly speaking, this was the policy mix that characterized the response to the 2008 financial crisis in the United States. The crisis was ushered in by a collapse in the housing market, rising interest rates, and defaulting subprime borrowers.

This had a domino effect that led to a crash in the global financial market, ultimately resulting in the Great Recession.

Fiscal and monetary policy can also push in different directions. The central bank might ease monetary policy while fiscal policymakers pursue austerity measures. This is what happened in Europe following the same financial crisis.

Or legislators, eager to win popular support, may decide to cut taxes or boost spending despite a tight labor market and inflationary pressures. These actions could force the central bank to raise interest rates.

Special Considerations

There are times when fiscal and monetary policymakers actually work together.

For example, the government may opt to provide fiscal stimulus by cutting taxes and increasing spending. The central bank may decide to provide monetary stimulus by cutting short-term interest rates. In response to a crisis, that combination of actions can stabilize or even jump-start economic activity.

The COVID-19 Pandemic

The COVID-19 pandemic which started in early 2020 threatened incalculable damage to the economies of nations around the world. Periodic shutdowns of retail businesses, restrictions on travel, and supply chain disruptions began, ended, and resumed unpredictably. Family routines were upended as work-at-home policies were hastily put in place. Many people lost their jobs, or quit them for fear of contagion.

This is the U.S. policy mix that was put in place in response:

The Federal Reserve cut interest rates, and vowed to keep rates at or near zero as long as necessary. It also began purchasing debt securities in massive amounts in order to help stabilize the financial markets.

Newly-elected President Joe Biden and the Congress pushed through an unprecedented package of direct assistance to those who had been hurt financially by the pandemic. Much of this assistance was targeted specifically to groups most severely impacted, including parents of school-age children, the unemployed, and small businesses.

In a commentary, a contributor to VoxEU, a policy analysis publication, argued that no nation could have gotten through the COVID-19 crisis without coordinated action by fiscal and monetary policymakers.

Which of the following is an appropriate monetary policy to reduce unemployment?

Which of the following is a fiscal policy action aimed at reducing unemployment?

What type of a combination of monetary and fiscal policies can be used by a country which is dealing with the problem of high unemployment?

How can the government use fiscal policy to increase aggregate demand and reduce unemployment?