Overview

This topic examines how government policies are used to stabilize the economy and manage inflation and unemployment. It covers the use of fiscal and monetary tools to influence demand, reduce economic fluctuations, and promote long-term growth. Understanding the trade-offs and timing of policies is key to evaluating economic performance.

Key Themes and Concepts

• Fiscal Policy: Government use of taxation and spending to influence aggregate demand. Expansionary policy fights recession; contractionary policy reduces inflation.
• Monetary Policy: Central bank control of money supply and interest rates to influence investment and spending. Tools include open market operations, discount rate, and reserve requirements.
• Policy Mix: The combination of fiscal and monetary policy used together. Coordination can enhance or hinder effectiveness.
• Inflation vs. Unemployment: Often a trade-off in the short run, as lowering unemployment may increase inflation and vice versa.
• The Phillips Curve:
  • Short run: Inverse relationship between inflation and unemployment.
  • Long run: No trade-off; economy returns to natural rate of unemployment.
• Expectations: Rational and adaptive expectations influence how quickly people adjust to policy changes, potentially reducing effectiveness.
• Deficits and Debt: Expansionary fiscal policy can create budget deficits. Long-term debt may affect interest rates, investment, and growth.

Quick Tip

Stabilization policy is about timing and trade-offs. Fiscal policy works fast but can cause debt; monetary policy is more flexible but can take time to affect the economy. Understanding the Phillips curve helps clarify how inflation and unemployment interact — and why expectations matter.