How to manage an economic crisis?

In these situations, when the imbalances come to produce a crisis in an economy, public policies have the responsibility to stabilize the countries’ economic growth. How to do it in the best way is the question that economists and policymakers ask themselves, and, as it is easy to imagine, the formulas for action are not always consistent with one another. Each school of economic theory formulates different hypotheses, and therefore different conclusions and practical recommendations. 

The two models of general reference in economics are the Neoclassical school on the one hand and Keynesian on the other. To face economic imbalances the recommendations of the two models and the economic policy suggested would be different due to the fact that  they depart from different assumptions of how the economy works1. 

The economic policy of the Neoclassical school rejects employing incentives to increase public spending – or in economic terms, ‘the incentive on the aggregate demand that is managed mainly by the fiscal policy’ . This is because this school believes that public spending would produce price increases as it assumes the economy is always at its full employment level -and therefore supply could not increase-. 

According to  neoclassical theory, situations of imbalance are rectified by the flexibility of prices and by the automatic mechanisms of the market.

On the contrary, for the Keynesians, the main instrument with which to intervene in the economy is indeed the fiscal policy. This is because it is the most effective instrument for counter-cyclical measures,  directly impacting the aggregate demand. The variations in public spending (by granting subsidies, lowering taxes, etc.) lead to an increase in people’s income which is considered to surely lead to an increase in consumption. Increased expectations leads to a further increase in investment. These series of chain reactions take place in a way that, in the end, the increases in income and GDP are greater than those initially generated by the public spending, due to what Keynesians call the ‘multiplier effect’. Therefore, managing the fiscal policy and with it, the aggregate demand, is how this model suggests generating the necessary changes that an imbalanced economic situation might require.

1 For more details on the different economic schools, check the chapter “Economic schools of thought: Labour perspective”.