Question

How can macro policy be used to combat problems of recession, overheating, and stagflation?

Answer 1

There are two basic economic policies that the nation can use to avoid or handle the cyclical problems such as recession overheating and stagflation. The policy that belongs to the Federal government is known as fiscal policy and the policy that belongs to the central bank or the Monetary Authority is known as the monetary policy.
To combat recession both monetary policy as well as fiscal policy can be used. An expansion in both the policies is required. Expansionary fiscal policy and expansionary monetary policy will stimulate the aggregate expenditure in the economy which will grease up the economic activity so that production is increased. Gradually the economy will reach its full employment level.
When the economy is overheated fiscal policy and monetary policies should b contracting in nature so as to discourage the aggregate expenditure in the economy. This will reduce the production and the GDP level so that the economy is shifted back to its original full employment equilibrium.
The case of stagflation is difficult because it is a situation in which there is a high unemployment as well as high inflation. An expansionary fiscal policy or a monetary policy will increase the level of employment and reduce the level of unemployment but it will be done at a cost of increased inflation which implies that inflation will now be much higher.
If monetary contraction or fiscal contraction is done then inflation will be under control but this will increase the level of unemployment further. In such cases supply side policies are helpful which shift the aggregate supply curve to the right so that the inflation is reduced and output is increased and in the process employment will also be increased.