Simple guide to managing aggregate demand

Economic fluctuations can result from fluctuations on the demand side (total nominal expenditures) or the supply side (general conditions of production). A countercyclical policy can stabilize the former, not the latter. The best we can do is keep aggregate demand on a steady path. Given stable demand, fluctuations in production, employment and inflation must be due to changes in technology, availability of resources and laws.

This does not mean that managing aggregate demand is easy. far from it. Maintaining the level of aggregate spending (or growing at a steady rate; both are beneficial) is difficult for policy makers. Monetary policy works better than fiscal policy. But even monetary policy, as long as it is managed by discretionary technocrats, is fraught with problems.

Fiscal policy is a bad way to stabilize aggregate demand. Government spending can change the composition of economic activity, but it rarely enhances it. There is a well-known adage in macroeconomics that says that fiscal policy should be “timely, purposeful, and temporary.” These prerequisites rarely hold up.

Suppose the economy is in a recession and fiscal policy may help. How likely is it that politicians (Congress and the President) will design a package of the right size, pass it before a recession turns into an expansion, and voluntarily cut back on post-recovery spending? Doubtful, to say the least.

Monetary policy works better in theory. Central bankers can make decisions much more quickly than elected officials. The relationship between the Federal Reserve’s main instrument, the monetary base (physical currency plus deposits in the Federal Reserve), and total spending is a relatively direct relationship (although far from static). Broad-based monetary stimulus can shock output while reducing distortions in relative prices.

Despite these advantages, monetary policy in practice is often in disarray. Look at all the harm the Fed failed to prevent, if not a direct cause: the Great Depression, the inflation of the 1970s, the Great Recession of 2007-2009, our current inflationary state. This is hardly encouraging! It seems that every generation of economists is destined to (re)learn that solving models and making good policy decisions are two very different problems.

Monetary policy can be improved by putting it on autopilot. The Fed should have one well-defined mandate that forces it to reach an outcome variable, such as a price-level target or a nominal spending target. Give him some freedom in the tools he uses, but there is no room for his primary goal. Clearly, just verbal warnings from lawmakers are not enough to keep the eyes of central bankers on the ball. When inflation reaches 9.1 percent, it is clear that something has gone wrong and must change. It is not enough to amend the FOMC members. “Getting the right central bankers” is as absurd as “getting the right politicians”. The goal is to make the process work well even when we have bad policymakers. If there is to be a central bank, let’s at least maintain strict restrictions.

Once we build good aggregate demand management institutions, aggregate supply is all that remains. Supply-driven economic fluctuations are not cyclical, strictly speaking. Things like epidemics, wars, and tax increases are not reliably cyclical. When they happen, we need a very different policy response than spending money or printing money.

Supply obstruction lowers sustainable maximum levels (or growth rates) of production and employment. Usually there is nothing we can do about it. What happens to inflation depends on the response of the demand side. If the central bank is to stabilize inflation, it will have to double the production and employment contraction. If nominal spending is fixed, it can allow inflation to absorb some of the blow to production and employment. I prefer the latter. But there is no way to have our cake and eat it too. Difficulties on the supply side generally make production more difficult. This is the source of our suffering, not the secondary policy response.

On the demand side, we should keep nominal expenditure as constant as possible. On the supply side, we should keep taxes low and lightly regulated. These simple policies may make even the most sophisticated people laugh at them. ignore them; They are very confident in their refinement abilities. In fact, we’ve progressed quite a bit beyond classic liberal prescriptions for free markets, good money, and peace. “Keep it simple you idiot” is good enough for government work.

Alexander William Salter

Alexander W Salter

Alexander William Salter is the Georgie J. Snyder Associate Professor of Economics at Rawls School of Business and a Comparative Economics Research Fellow at the Free Market Institute, both at Texas Tech University. He is a co-author of Money and the rule of law: generality and predictability in monetary institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion articles in leading national media outlets such as The Wall Street JournalAnd the National ReviewAnd the Fox News opinionAnd the hill.

Salter holds master’s and doctoral degrees. He holds a PhD in Economics from George Mason University and a BA in Economics from Occidental University. He was a participant in the AIER Summer Fellowship Program in 2011.

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