Historical Background to Fiscal and Monetary Policies

Most of the policy options available to the government today to curb economic adversity were an offshoot of the 1930s great depression whose adverse effects were widespread. The predominant characteristic of the depression that lasted for 10 years was a decline of output by 30 percent and increase in unemployment levels by 25 percent (Colander, 2008, p. 202). All this was not out of lack of will to do work but because the market was not availing any work to be done. With the great depression the initial view point of classical economics that concerned itself with long-term issues and growth were not tenable – new approaches that could lead to faster recovery were needed (Colander, 2008). Leading the clamour for new ways focused on short-run issues, was John Maynard Keynes whose advances in The General Theory of Employment, Interest and Money formed the basis on which modern macroeconomics were launched (Colander, 2008). Economists who supported this new approach have thus come to be referred to as Keynesian economists to differentiate them from their Classical opponents who favour the original macroeconomics perspective focused on long-run issues (Colander, 2008).

Keynes approach, on the contrary, advanced that short-run interventions would help the market towards its long-run recovery, absence of which then the economy might not recover within the people’s acceptable time frame and would result into more grave problems – according to Keynes such as fascism and communism (Colander, 2008).The new school of thought introduced new approaches for dealing with economic adversity. Whereas the traditional approach was one advanced on a laissez-faire basis where the market was believed to have the capacity to self-regulate through the pricing mechanism – that only needed the hand of time – the great depression hand no such time to lend (Colander, 2008). Eventually then the new perceptive changed from questions on whether the economy could redeem itself from the great depression, to what short-term approaches the society could use to counteract the forces of the depression (Colander, 2008).  One of these short-term interventions was eventually formed, with the government being proposed as critical player whose intervention could help hold up aggregate expenditures (Colander, 2008). Out of such Keynesian concepts the model of aggregate supply/aggregate demand – AS/AD – was developed in the 1950s with three curves: (a) the short-run aggregate supply curve (SAS curve) that describes the short-run supply trend of the aggregate economy; (b) the aggregate demand (AD) curve describe the short-run demand trend; and (c) long-run aggregate supply curve (LAS curve) that describes “the highest sustainable level of output” (Colander, 2008, p. 205). Go to part 3 here.

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