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To face economic imbalances the recommendations of the policy avenues aforementioned would be different essentially because they are departing from different assumptions regarding how the economy works. Therefore, the economic policy of the Neoclassical school rejects the use of incentives to increase the aggregate demand because doing so would produce price increases as they believe the economy is always at its full employment level. As a consequence, this line of analysis would avoid using fiscal policy, as the main objective of this policy is to affect the aggregate demand. For neoclassical theory, the imbalance situations are rectified by the flexibility of prices and the automatic mechanisms of the market. These are the adjustment mechanisms in this neoclassical model that results in the rejection of any other public intervention.

Regarding  monetary policy, although in the long term the variations in the money supply do not have much effect on income (since once the level of full employment is reached, it then cannot be exceeded), in the short term they are an adequate means to expand or contract the aggregate demand as the variation of the interest rate control consumption, investment and credit. In sum, the neoclassical model predicts that expansionary fiscal policy will only procure price increases, so the defenders of this model suggest monetary policy as the main instrument to intervene on the imbalances of the macroeconomic variables.

On the contrary, for Keynesians, the main instrument to intervene in the economy is fiscal policy due to its direct impact on aggregate demand. The variations in public spending lead to an increase in aggregate demand and income. Surely, this increase leads to a new increase in consumption opening up better expectations that, once again, lead to a further increase in investment. Thus, a series of chain reactions take place that, in the end, increases in income and gross domestic product (GDP) are greater than those initially generated by original expectations, 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.

For Keynesians, the mechanisms of monetary policy do not differ from the neoclassical  model. In other words, if the interest rate is high the agents have more incentives to save, and if the interest rate is low, they have more incentives to invest and consume. The difference lies, however, in the effectiveness of the monetary policy. First, Keynesians question the actual effect of for instance lowering the interest rate as an instrument for stimulating the economy, considering that investment is such a volatile variable that depends rather on other circumstances: on the expected benefits, on the general conditions of the economy and of the expectations of the entrepreneurs. Secondly, Keynesians question the impact of monetary policy in times of recession. If the economy is on an expansive trajectory, many loans are requested and granted, stimulating the creation of bank money. In contrast, in a recessionary economy, the supply of bank money will even be reduced as more loans are repaid than taken out. Here, the private sector acts pro-cyclically and therefore makes the crisis bigger. In this situation, only the creation of money by deficit spending can help. The chain by which variations in the quantity of money transmit monetary impulses to the economy would be broken. For this reason, Keynesians argue that monetary policy is not effective in achieving increases in production, income, and employment.

Based on the main ideas in which each model bases their theories and their assumptions, we could simplify the suggestion of each theory as follows:









Full employment 


Adjustment mechanism


Interest rate, Income

Public intervention

No, markets can regulate themselves automatically

Yes, the economy needs regulation 

Fiscal Policy 

No, it will only produce price increments because the economy is already at full employment levels

Yes, it will help the economy to recalibrate, affecting the aggregate demand thanks to the multiplier effect

Monetary Policy 

Only efficient in the short term – mechanism used to intervene in imbalances

No, it is not efficient to affect growth, income or employment

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