Chapter 13: Problem 16

If the economy is suffering through a rampant inflationary period, would a Keynesian economist advocate for stabilization policy that involves higher taxes and higher interest rates? Explain your answer.

Short Answer

Expert verified

Yes, a Keynesian economist would typically advocate for stabilization policies that involve higher taxes and higher interest rates during a rampant inflationary period. This is because these policies aim to reduce aggregate demand, which helps to stabilize prices and cool down the economy. However, it is important to note that the specific combination of policies and their effectiveness will depend on the unique economic circumstances and various factors at play in each situation.

Step by step solution

Understand Keynesian economics

Keynesian economics is an economic theory that emphasizes the role of government intervention and fiscal policies to stabilize the economy in the short term, particularly during economic downturns. It was developed by the British economist John Maynard Keynes during the Great Depression. The primary focus of this theory is that aggregate demand (total spending in the economy) is the driving force of economic growth and that during economic recessions, there might be insufficient aggregate demand to achieve full employment.

Identify the problem: Inflation

Inflation is the rate at which the general price level of goods and services in an economy is increasing over time. Inflation erodes the purchasing power of money, so it is a negative factor that affects both consumers and producers. Some of the reasons behind inflation include high demand for goods and services, increased cost of production, or an increase in the money supply.

Keynesian approach to inflation

During inflationary periods, Keynesian economists would recommend stabilization policies that aim to reduce aggregate demand, thus helping to stabilize prices. This is accomplished by using fiscal and monetary policies, both of which can have impacts on inflation and the economy as a whole.

Fiscal policy: Higher taxes

In the case of fiscal policy, a Keynesian economist might advocate for higher taxes, especially on higher-income earners. This would reduce their disposable income and subsequently decrease consumption, leading to a reduction in aggregate demand. The decreased demand would help cool down the economy and curb inflation.

Monetary policy: Higher interest rates

In terms of monetary policy, a Keynesian economist might recommend increasing interest rates. Higher interest rates make borrowing more expensive, which leads to a decrease in consumption and investment. As a result, aggregate demand falls, and the economy cools down, helping to control inflation. In conclusion:

Answer: Would a Keynesian economist advocate for higher taxes and higher interest rates during inflation?

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