Question

In the Great Depression, why did Keynes think about the relative reliability and effectiveness of Fiscal and Monetary policy?

Answer 1

During the Great Depression, it was observed that the Classical Regime suggestions were failing to revive the economy and immediate steps had to be taken to close the recessionary gaps.

Keynes suggested that there is an immediate government intervention required to correct the economic situation. He was in favor of Expansionary Fiscal Policy.

However, he also pointed out that there exists bottlenecks in terms of price and wage flexibility. Both are rigid downwards and might not adjust as per the supply and demand conditions. Because of these problems the economy will always be at sub-optimal equilibrium with less than full potential output.

However, such situation can be overcome by the use of Monetary Policy wherein the Central Bank raises the flow of money supply into the economy. Such increase in the money supply would close the extra gap and would bring the economy back to equilibrium

Hence, the effectiveness of both Fiscal and Monetary Policy is required to achieve long run goals.