Here we detail about the two types of policies adopted to overcome recession and unemployment, (1) Monetary policy, and (2) Fiscal policy.
Type 1# Monetary Policy:
Under monetary policy, through expansion in money supply rate of interest can be lowered which will encourage private investment.
With the increase in private investment, aggregate demand will increase (that is, aggregate demand curve will shift upward) which will raise the equilibrium level of employment. As a result, the economy will be lifted out of recessionary conditions and unemployment will be removed.
However, Keynes had serious doubts about the effectiveness of monetary policy. He was of the view that in times of depression rate of interest is already very low and at this liquidity preference curve of the community (that is, the curve of demand for money to hold) is absolutely elastic, that is, it is of horizontal shape. Therefore, in this situation when money supply is increased, rate of interest will not fall. Thus, with no fall in the rate of interest, private investment will not pick up further.
Type 2# Fiscal Policy:
In view of ineffectiveness of monetary policy, Keynes laid stress on the role of fiscal policy in curing recession/depression and removing involuntary unemployment. Under the fiscal policy, a major measure is the increase in expenditure by the Government on several types of public works in times of depression.
The increase in Government expenditure will cause an upward shift in the aggregate demand curve. This increase in aggregate demand will bring about increase in employment and output. If the increase in Government expenditure and as a result rise in aggregate demand is sufficient, it will help in achieving equilibrium at full-employment level.
As a result, depression and involuntary unemployment will be eliminated. It is worth noting that in this regard Keynes put forward a theory of multiplier which strengthened the case for raising Government expenditure on public works in times of depression or when large-scale unemployment prevailed in the economy.
Briefly, theory of multiplier implies that increase in Government expenditure will raise aggregate demand and therefore output and employment not by the amount of increase in Government expenditure but by a multiple of it.
Another important measure of fiscal policy to raise employment and output is the reduction in taxes. When rates of personal taxes such as income tax are reduced, disposable income of the people increases which brings about rise in their demand for consumption. The rise in consumption demand pushes up aggregate demand curve and helps in removing recession and unemployment.
It may be noted that on the recommendations of Keynesian economists American President John Kennedy made a drastic cut in income taxes in 1964. This had a great success as output and employment in the USA increased significantly and, as a result, recession and unemployment were removed.
Cut in personal taxes to boost aggregate demand has also been applied in later years in the USA as well as in Great Britain. Recently in 2003, the then President of the USA Geoge W. Bush has made a 3.5 billion cut in taxes to revive the American economy.
In the end, it is important to note that modern economists though agree with Keynes’ view about the effectiveness of fiscal policy in curing recession, they do not share Keynes’ view about the ineffectiveness of monetary policy. It may however be noted that, according to the modern Keynesians and others, liquidity preference curve of the community is fairly elastic even in times of recession which implies that expansion in money supply will cause a decline in interest rate and will therefore stimulate private investment.
Further, according to them, investment demand curve is also fairly elastic which implies that fall in interest rate will have significant impact on private investment. Thus, according to modern economists, both monetary and fiscal policies are important instruments whereby aggregate demand of the economy can be changed.