What action could the federal government take to help bring the economy back to potential output and full employment?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In the situation that you describe, the economy must be in a recession.  When an economy is in a recession, there are a number of things that a government can do to try to get back to full employment and potential output.

In fiscal policy, the government could increase spending and/or cut taxes.  By doing these things, it would be stimulating aggregate demand.  The changes in fiscal policy would put more money in the hands of consumers.  They would spend that money, thus increasing aggregate demand.  This would, if all went right, get the economy out of the recession.

In monetary policy, the government could increase the money supply.  It could do this in one or more of three ways.  It could decrease the percentage of deposits that banks are required to hold as reserves.  It could lower interest rates.  It could buy government securities on the open market.  All of these would increase the money supply and move the economy back toward potential output.

Classical economists and supply-siders would say that the government needs to focus on aggregate supply, not on aggregate demand.  They would say the government should do things like lowering taxes (particularly on things like businesses and investments) and reducing the amount of regulation of the economy.  These would encourage businesses to invest and would increase aggregate supply, thus returning the economy to full employment and potential output.

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