Let’s return to the question that began this chapter: When the president and Congress cut government spending, how should the Federal Reserve respond? As we have seen, government spending is one determinant of the position of the aggregate-demand curve. When the government cuts spending, aggregate demand will fall, which will depress production and employment in the short run. If the Federal Reserve wants to prevent this adverse effect of the fiscal policy, it can act to expand aggregate demand by increasing the money supply. A monetary expansion would reduce interest rates, stimulate investment spending, and expand aggregate demand. If monetary policy responds appropriately, the combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected. This analysis is exactly the sort followed by members of the Federal Open Market Committee. The know that  monetary policy is an important determinant of aggregate demand. They also know that there are other important determinants as well, including fiscal policy set by the president and Congress. As a result, the Fed’s Open Market Committee watches the debates over fiscal policy with a keen eye This response of monetary policy to the change in fiscal policy is an example of a more general phenomenon: the use of policy instruments to stabilize aggregate demand and, as a result, production and employment. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946. This act states that “it is the continuing policy and responsibility of the federal government to .. promote full employment and production.” In essence, the government has chosen to hold itself accountable for short-run macroeconomic performance. The Employment Act has two implications. The first, more modest, implication is that the government should avoid being a cause of economic fluctuations. Thus, most economists advise against large and sudden changes in monetary and fiscal policy, for such changes are likely to cause fluctuations in aggregate demand. Moreover, when large changes do occur, it is important that monetary and f sea. policy makers be aware of and respond to the other’s action The second, more ambitious, implication of the Employment Act IS mat the government should respon to changes in the private economy to stabilize aggregate demand. The act was passed not long after the publication of Keynes’s The General Theory of Employment, Interest, and Money, which has been one oi
the most influential books ever written about economics. In it, Keynes emphasized the key role of aggregate demand in explain short-run economic fluctuations. Keynes claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level Keynes (and his many followers) argued that aggregate demand fluctuates because of large y irrational
waves of pessimism and optimism. He used the term “animal spirits” to refer to these arbitrary changes it attitude. When pessimism reigns, households reduce consumption spending, and firms reduce investment spending. The result is reduced aggregate demand, lower production, and higher unemployment Conversely, when optimism reigns, households and firms increase spending. The result is higher aggregate demand, higher production, and inflationary pressure. Notice that these changes in attitude are, to some extent, self-fulfilling. In principle, the government can, adjust its monetary and fiscal policy in response to these waves of optimism and pessimism and, thereby, stabilize the economy. For example, when people are excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand. Former Fed chairman William Martin described this view of monetary policy very simply: “The Federal Reserve’s job is to take away the punch bowl just as the party gets going.”