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The current economic recession has shifted the public’s attention to these classic theories of microeconomics and macroeconomics. Unless you’ve taken courses in school or read economics books, then you’re likely a little in-the-dark when you hear terms like “aggregate demand,” “scarcity” and “Keynesianism.” Never fear, friend, you don’t need a degree in economics to understand how the economy went so wrong and how its going to be fixed.

Fiscal policy is one area of macroeconomics aimed at managing the economy, particularly during a recession. It’s believed that through new tax and spending policies, the government can encourage better economic growth. However, as Obama’s economics research advisor, Christina Romer, wrote in a 1992 article: “Fiscal policy… contributed almost nothing to the recovery before 1942.” Yet in some cases, UC Santa Cruz Professor Carl E. Walsch warns, the fiscal policy to reduce the money supply is warranted. Walsh writes, “If a government is already running a large deficit, spending increases might lead financial markets to question the solvency of the government or to expect that taxes will need to be raised in the future. This can cause long-term interest rates to rise, restraining current investment spending and negating the expansionary effects of the government spending.” Additionally, he argues, the impact of providing tax cuts and stimulus money to citizens can be overestimated if consumer confidence is low and the people feel the benefits are just temporary.

Another concept of macroeconomics that applies to recessions is called monetary policy. Unlike fiscal policy, which is regulated by the President and Congress, monetary policy is regulated by the Federal Reserve System, the nation’s central banking institution. During a recession, the Federal Reserve has the power to reduce the reserve ratio or lower the federal funds rate, which lets banks keep more of their assets as accessible money, rather than reserves, thereby offering more attractive loans to customers and keeping economic growth high. Another action the Federal Reserve may take is to lower the discount rate on federal loans, which can free up money for banks that have borrowed from the Reserve, thus offering consumers better loans. Lastly, the Federal Reserve may save its own money to buy government bonds and put more money into the economy. While some of these actions may sound good, they must be careful not to meddle in free markets too much or the economy may wind up in worse shape than before.

So what have macroeconomics followers learned from this mess? Maybe it’s time for new economics theories to take hold, rather than simply drawing on the economics history of the past. “Economists need to reach out from their specialized silos: macro-economists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst,” suggests a July 16th 2009 article in The Economist, “For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.”

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