KW_Macro_Ch_10_Sec_05_Macroeconomic_Policy

KW_Macro_Ch_10_Sec_05_Macroeconomic_Policy - chapter 10...

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>> Aggregate Supply and Aggregate Demand Section 5: Macroeconomic Policy chapter 10 We’ve just seen that the economy is self-correcting in the long run: It will eventually trend back to potential output. Most macroeconomists believe, however, that the process of self-correction takes several years—typically a decade or more. In particular, if aggregate output is below potential output, the economy can suffer an extended peri- od of depressed aggregate output and high unemployment before it returns to normal. This belief is the background to one of the most famous quotations in economics: John Maynard Keynes’s declaration, “In the long run we are all dead.” Economists usually interpret Keynes as having recommended that governments not wait for the economy to correct itself. Instead, it is argued my many economists, but not all, that the government should use monetary and fiscal policy to get the economy back to potential output in the aftermath of a shift of the aggregate demand curve. This is the rationale for an active stabilization policy, which we defined in Chapter 6 as the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.
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Can stabilization policy improve the economy’s performance? If we reexamine Figure 10-4, the answer certainly appears to be yes. Under active stabilization policy, the U.S. economy returned to potential output in 1996 after an approximately six- year recessionary gap. Likewise, in 2001 it also returned to potential output after an approximately four-year inflationary gap. These periods are much shorter than the decade or more that economists believe it would take for the economy to self-correct in the absence of active stabilization policy. However, as we’ll see shortly, the ability
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