Macroeconomic policy

Lane Kenworthy, The Good Society
April 2025

Macroeconomic policy consists mainly of fiscal policy and monetary policy. Fiscal policy is government spending and taxing. Higher government expenditures and lower taxes help to stimulate the economy by increasing the demand for goods and services. Monetary policy is primarily the setting of (short-term) interest rates. Lower interest rates stimulate the economy by reducing the cost of borrowing.

The core aims of macroeconomic policy are: (1) to achieve an environment in which the economy grows and wages rise while inflation is modest; (2) to avoid excessive government debt.

Fiscal policy is conducted by elected policymakers. Monetary policy in the rich longstanding-democratic countries typically is handled by an independent central bank — an agency appointed by elected policymakers but not subject to their control or influence in making its decisions.

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TIGHT LABOR MARKETS WITH LOW INFLATION

The core challenge of macroeconomic policy is to set government spending, government taxing, and interest rates at levels that will be conducive to economic growth and rising living standards.

When employers can benefit from hiring more workers but find it difficult to do so, they are more likely to increase wages. The key indicator here is the unemployment rate. A low unemployment rate (sometimes called “full employment”) suggests there are relatively few people who don’t have a job but want one. In this situation, employers will be willing to offer a higher wage in order to attract additional workers and keep the ones they have. Wages will tend to rise. The longer the labor market remains tight, the stronger the pressure on employers to increase wages and salaries.

Monetary policy is key here. The central bank needs to be willing to resist raising interest rates when the unemployment rate gets low enough to potentially cause a jump in inflation.

In the United States, the central bank’s tendency since the high-inflation period of the late 1970s and early 1980s has been to increase interest rates quickly and sharply when the unemployment rate falls to 5% or 6%. The only exceptions — the only post-1979 periods in which the Federal Reserve held the unemployment rate below 5% — were 1997-2000 and 2015-24. And as we see in figure 1, those are the only periods in which there was a noteworthy increase in pay levels for Americans in the middle and below.1

Figure 1. Pay at the 10th and 50th percentile
Hourly pay. P10 is the 10th percentile of the wage distribution; P50 is the 50th percentile. 2024 dollars; inflation adjustment is via the chained CPI-U. Data source: Economic Policy Institute, Economic Policy Institute, State of Working America Data Library, “Hourly wage percentiles,” using Current Population Survey (CPS) data. The shaded periods are years in which the unemployment rate was nearly always below 5%: 1997-2000 and 2015-2024.

This can be a delicate balancing act. If the unemployment rate stays too low for too long, wages may rise too rapidly, and firms may begin to pass this increase in their labor costs on to consumers by raising the price of the goods and services they sell. This is inflation.

When the rate of inflation is low and stable, it causes few if any problems for companies and households. But when inflation is high and/or inconsistent, it can wreak havoc on economic actors. Firms and households find it more difficult to anticipate their expenses and to plan how to pay them. And if prices rise faster than wages and incomes, people’s real living standard declines.

Moreover, inflation can become more and more difficult to reduce. When inflation rises, economic actors may begin to anticipate large prices increases. Workers and labor unions that represent them in pay negotiations will demand larger increases in wages in order to keep real (inflation-adjusted) pay levels from decreasing. Suppliers of parts, components, and services will increase the prices they charge to other firms in order to ensure they can meet their rising expenses. Businesses that sell to consumers will, in turn, raise their prices. In this way, inflation can become embedded in expectations. This can cause further increases in the inflation rate. And it can make it more difficult to bring inflation back down to an acceptable level.

This is what happened in the late 1970s and the early 1980s, as we see in figure 2. Eventually, central banks — beginning with America’s central bank, the US Federal Reserve — raised interest rates to a level high enough to cause a deep economic recession. This weakened the ability of economic actors to raise their prices, bringing inflation rates back down to relatively modest levels. But the cost was a sharp increase in joblessness and slower economic growth.

Figure 2. Inflation
Average annual change in the consumer price index. Data source: OECD Data Explorer, “Consumer price indices (CPIs, HICPs), COICOP 1999.” Thick line: United States.

Things were very different from 1990 to 2020. The average inflation rate in the rich democratic countries during those three decades was just 2.1%. And not only was it low; it was low and stable.

In the early 2020s, the Covid-19 pandemic caused people to purchase fewer in-person services and more goods. This led to a disruption in supply chains and a consequent rise in the price of many goods. As of 2024, the resulting increase in inflation looks to have been short-lived. The average inflation rate across these countries in 2024 was just 2.4%, similar to the average over the 1990-2020 period.

Fiscal policy — government spending and taxing — always matters, but it is particularly important when the economy goes into recession (a period in which an economy has negative economic growth for half a year or more). Recessions usually occur because demand for goods and services decreases significantly. Many things can cause this, including a simple loss of confidence in the economy that eventually becomes a self-fulfilling prophecy. Regardless of the cause, when the economy goes into a downturn the central bank typically will reduce interest rates. But this may not be sufficient to turn the economy around.

In that case the government may need to temporarily increase expenditures or reduce taxes, or both, in order to increase demand.2 Some of this happens automatically. Government programs such as unemployment insurance will begin paying out more money as more people become unemployed.3 But some additional temporary stimulus may be necessary. The challenge is to get the timing and the quantity of stimulus correct. When a downturn is mild, this isn’t too difficult. In deeper or lengthier recessions, it can be significantly harder.

During the Great Recession, the US government passed two fiscal stimulus measures, one in 2008 (1% of GDP) and another in 2009 (6% of GDP).4 These helped prevent a repeat of the 1930s depression. And yet they turned out to be smaller than what was needed.5 As a result, the unemployment rate didn’t return to its pre-recession level until eight years later, in 2015, as figure 3 shows. Fiscal stimulus in much of western Europe was even more inadequate, resulting in prolonged high jobless rates in a number of countries.6

Figure 3. Unemployment
Share of the labor force age 15 and over. Data source: OECD Data Explorer, “Monthly unemployment rates.” Thick line: United States. “Asl” is Australia; “Aus” is Austria.

In February 2020 the US unemployment rate was 3.5%. The Covid-19 pandemic broke out in March. By April a significant portion of the economy had shut down and the unemployment rate jumped to 15%. The Federal Reserve quickly reduced interest rates. But interest rates had already been fairly low — a legacy of the lengthy effort to pull the economy fully out of the aftermath of the 2008-09 Great Recession. The government passed a large stimulus package in March 2020 (10% of GDP).7 In early 2021 the Biden administration and congress agreed to another equally large stimulus (10% of GDP).8 These fiscal stimulus efforts ensured that the economy returned to solid growth and low unemployment quite quickly.

The second stimulus package also, however, likely contributed to a rise in inflation beginning in 2021. Policymakers were worried that they would provide too little stimulus money, as they had during and after the Great Recession. At the same time, the unemployment rate had already dropped to 6% by February of 2021. Could policymakers have done better by opting for a smaller stimulus in early 2021? Yes, but their choice to go big is understandable, given how slowly the economy had recovered from the 2008-09 downturn.

When inflation increased in 2021, some analysts concluded that bringing it back down to 2-3% would require a lengthy period of high unemployment, like in the early 1980s.9 But the Federal Reserve elected not to raise interest rates dramatically. Instead it proceeded with regular but cautious interest rate rises. That turned out to be a wise choice. The unemployment rate remained below 5% (figure 3 above), helping wages to rise (figure 1), and yet inflation subsided steadily beginning in late 2022 and within two years had fallen to around 3% (figure 2).10

A BALANCED BUDGET OVER THE BUSINESS CYCLE

Government debt is inevitable and helpful. Governments borrow money to fund new programs, to increase demand during economic downturns, to pay for crisis mitigation or alleviation, and to cover occasional shortfalls in revenues. But too much debt can be harmful. It forces a significant portion of revenues to go toward interest payments, which means those revenues can’t be used for government programs that provide economic security, boost capabilities, raise low-end living standards, and improve people’s lives in other ways. Moreover, a country with a high level of debt is likely to be charged a higher interest rate if and when it needs to borrow additional funds.11

The key to keeping government debt at a manageable level is a commitment to genuine Keynesianism in fiscal policy. Keynes argued for deficit spending during economic recessions, in order to compensate for a shortfall in private-sector demand.12 “The boom, not the slump, is the right time for austerity at the Treasury,” wrote Keynes in 1937, meaning that government running a fiscal deficit during a recession can help to stimulate the economy and keep the recession as small and short as possible.

After World War II some policy makers in the rich countries shifted to a view that deficit spending should be used to stimulate the economy on a regular basis, not just during downturns.13 But the quote from Keynes makes clear that he recommended running a surplus when the economy is growing. Doing so allows a country to keep its budget in balance over the business cycle.14

Figure 4 offers a sense of the degree to which countries do this. It shows budget balances by the unemployment rate. The data points are years. In most countries we see a strong downward slope to the pattern. When the unemployment rate is higher (to the right on the horizontal axis), the government budget is more likely to be in deficit (lower on the vertical axis). This is as we would expect: high unemployment spurs government to temporarily increase spending and/or reduce taxes in order to stimulate demand.

The question is where a country ends up, on average, on the vertical axis. Some nations — Denmark and Finland, for example — have just as many years above zero on the vertical axis as below. That means their budget is in balance on average. They run a deficit to help pull the economy out of downturns, but they run a surplus when the economy is doing well. Other countries, such as the United States, are mostly below zero on the vertical axis, which means they tend to run a deficit regardless of how the economy is doing.

Figure 4. Unemployment and government budget surplus or deficit
The data points are years. 1970-2023. Unemployment rate: share of the labor force age 15 and over. Data source: OECD Data Explorer, “Monthly unemployment rates.” Budget balance: government revenues minus expenditures, measured as a share of GDP. Above zero on the vertical axis indicates a government budget surplus; below zero indicates a government budget deficit. Data source: OECD Data Explorer, “Public finance main indicators — Government at a glance, Yearly updates.” Norway isn’t included because it consistently runs very large surpluses due to its oil wealth. The lines are linear regression lines.

Countries that don’t offset deficit years with surplus years will tend to build up a debt. Figure 5 shows that only a handful of the affluent democracies have avoided accumulating a government debt in recent decades.

Figure 5. Government surplus or debt
Government financial assets minus government financial liabilities, measured as a share of GDP. Above zero on the vertical axis indicates a government surplus; below zero indicates a government debt. Data source: OECD, data.oecd.org, series general government financial wealth. Norway, which has a surplus (negative net debt) of better than 200% of GDP, isn’t shown. Thick line: United States. “Asl” is Australia; “Aus” is Austria.

SUMMARY

Fiscal policy and monetary policy aim to combine a tight labor market with low inflation, and to do so without running up a sizable government debt. These aims have proved difficult for the rich democratic nations to achieve.

At the same time, our knowledge base is increasing, and performance in poor and/or dangerous times arguably has improved. The policy response to the Great Recession of 2008-09 was better than the response to the Great Depression in the 1930s, and the response to the Covid-19 downturn was better still.

  1. Robert Pollin, “Back to Full Employment,” Boston Review, 2011; Dean Baker and Jared Bernstein, Getting Back to Full Employment, Center for Economic and Policy Research, 2013; Isabel Sawhill, Edward Rodrigue, and Nathan Joo, “One Third of a Nation: Strategies for Helping Working Families,” The Brookings Institution, 2016; Jared Bernstein, Ben Spielberg, and Keith Bentele, “The Relationship between Tight Labor Markets and the Earnings of Low-Income Households,” Yankelovich Center for Social Science Research, University of California-San Diego, 2017; Jared Bernstein, “The Importance of Strong Labor Demand,” in Revitalizing Wage Growth: Policies to Get American Workers a Raise, edited by Jay Shambaugh and Ryan Nunn, Hamilton Project and the Brookings Institution, 2018; Josh Bivens and Ben Zipperer, “The Importance of Locking in Full Employment for the Long Haul,” Economic Policy Institute, 2018; Jared Bernstein, “Recent Wage Trends Are Impressive. Their Levels … Not So Much,” Washington Post: Post Everything, 2019; Jared Bernstein and Keith Bentele, “The Increasing Benefits and Diminished Costs of Running a High-Pressure Labor Market,” Center on Budget and Policy Priorities, 2019; Katherine S. Newman and Elisabeth S. Jacobs, Moving the Needle: What Tight Labor Markets Do for the Poor, University of California Press, 2023; David Autor, Arindrajit Dube, and Annie McGrew, “The Unexpected Compression: Competition at Work in the Low Wage Labor Market,” Working Paper 31010, National Bureau of Economic Research, 2024. ↩︎
  2. Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton, 2009; Krugman, End This Depression Now!, W.W. Norton, 2012. ↩︎
  3. Government can establish an additional stimulus mechanism automatically triggered by indicators that signal the economy is entering a recession. Wikipedia, “Sahm Rule.” ↩︎
  4. The 2008 Economic Stimulus Act and the 2009 American Recovery and Reinvestment Act. ↩︎
  5. Krugman, End This Depression Now!; Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, Penguin, 2013. ↩︎
  6. Krugman, End This Depression Now! ↩︎
  7. The 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act. ↩︎
  8. The 2021 American Rescue Plan Act. ↩︎
  9. Larry Summers, “Secular Stagnation or Secular Stagflation?,” London School of Economics, June 20, 2022; Jordan Weissmann, “Why Larry Summers Thinks We Need Massive Unemployment to Beat Inflation,” Slate, July 7, 2022. ↩︎
  10. Paul Krugman, “Inflation,” Paul Krugman Substack, March 16, 2025. ↩︎
  11. Noah Smith, “This Is Called ‘Capital Flight’,” Noahpinion, Substack, 2025. ↩︎
  12. Krugman, The Return of Depression Economics and the Crisis of 2008. ↩︎
  13. John Kenneth Galbraith, The New Industrial State, Princeton University Press, (1967) 2007. ↩︎
  14. Carles Boix, “Partisan Governments, the International Economy, and Macroeconomic Policies in Advanced Nations, 1960-93,” World Politics, 1998; Jonas Pontusson, “Once Again a Model: Nordic Social Democracy in a Globalized World,” in What’s Left of the Left?, edited by James Cronin, George Ross, and James Shoch, Duke University Press, 2011; Paul Krugman, “The Fraudulence of the Fiscal Hawks,” New York Times, 2018; Krugman, “Why We Should, But Won’t, Reduce the Budget Deficit,” New York Times: Paul Krugman Newsletter, 2023. ↩︎