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Question from Past Macroeconomics Qualifying Exam (Spring, 2006 - Question three) at George Mason UniversityEdit

Explain the positions of Keynesians, monetarists and rational expectionists on the feasibility and desirability of stabilization policy. To what extent are the slopes of the IS and LM schedules relevant to the controversy over whether or not it is desirable to attempt to stabilize the economy by contra-cyclical monetary policy?


Keynesian economist would argue that an expansionary fiscal or monetary policy will stimulate aggregate demand in the short term. For expansionary fiscal policy, Keynesians argue that the increase in money supply will cause the interest rate to decline, desired national savings to decline, and consumption to rise, stimulating aggregate output level above its full-employment level of output. Keynesian agree that in the long term price will rise and the real money supply to fall back to its original levels, however, they argue that since "in the long term we are all dead", on the short term should matter. Monetarist on the other hand, advocate the use of monetary policy, through the use of key short term interest rates to stimulate the economy during an economic recession, and control inflation during expansions. Rational expectation economist on the other hand argue that rational agents will not be fooled by anticipated changes monetary policy (money illusion) and that the Recardian Equivalence will counter any attempt by the government to stimulate the economy through an expansionary fiscal policy. RE economists concede however that unanticipated changes can have a real effect on the economy, only to the extent that the policy results in unanticipated changes.

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