Question

Why might an active policy approach be more politically popular than a passive approach, especially during a recession?

Answer 1

To know which one is better, let us first understand both types of approaches An active policy approach is one where the actions by the Fed or by the government are made in response to economic conditions. In a passive policy approach, federal government allows existing policy to remain unchanged and leave the economy to automatic stabilizers.

So what happens in case of recession, during recession an economy is relatively unstable and is unable to recover from shocks on their own. Economic fluctuations arise primarily from the private sector, particularly investment, and the market forces or the automatic stabilizers are not able to help or even if they do the effect will be very slow to see any impact in short run.

In this case government intervention and discretionary policy should be implemented to move economy to potential output i.e. an activepolicy apporach should be followed. Discretionary (monetary) policy can reduce costs of unstable economy such as higher unemployment.

We need to understand that Wages are not that flexible and adverse supply shocks and sagging demand push unemployment above natural rate and in such cases market forces are too slow to respond. If government follow the passive approach, there will be high cost associated with it as the longer market forces take to reduce unemployment to natural rate, the greater the output lost and inturn there will be high economic as well as psychological cost to the ones who are unemployed.

So when closing a recessionary gap,in an active approach, AD curve shifts right as government tries to stimulate demand.

The government should reduce economic fluctuations by stimulating aggregate demand when output falls below its potential level as in case of a recession. Government’s active policy approach to reduce the fluctuations of the business cycle may not be perfect but its is still better than the passive approach of not doing anything at all.