Question

The Great Recession was the most serious economic downturn in U.S. history since the Great Depression. The recession began in December 2007. Interest rates at the time were very low, close to zero. Despite the American Recovery and Reinvestment Act of 2009, a nearly $800 billion fiscal stimulus and an expansionary monetary policy, the economy is only now getting back to normal in 2015. In retrospect, what set of macro policies, if anything, should we have conducted to achieve a better recovery? Explain your reasoning. Be sure to address the arguments favoring active versus passive policymaking as they relate to your discussion.

Answer 1

Active policy making essentially means that the government increases spending, changes taxes, fed changes interest rates in order to propel the economy, whereas in the case of passive policymaking it continues to not alter any government spending, interest rates and taxes year after year.

The interest rates were lower close to zero by December 2008. Leaving no headroom for further rate cuts. Thus as the monetary authority had set a target of maintaining inflation level at 2% per year, it did not give enough room for them as they had to slash the rates immediately to cut down the inflation rate. But if the Monetary authority could have targeted a 4% inflation rate, then the nominal short term interest rates would have been higher in December 2007 and the Fed could have had more room to cut down future interest rate, which would have stimulated the economy faster. For example if the nominal interest rates were 6% in December 2007, and the inflation targeted was higher at 4%. Then the fed could have cut interest rates by 6%, thus providing more stimulus to the economy. This could have brought the economy back on track much faster.

Fiscal stimulus should have been greater and created more jobs, as the financial response created more jobs and boosted the real GDP much more than the fiscal stimulus, and should have focused on bailing out banks equally as they are vital for the ecosystem and stops the crisis from spreading further in the economy.