Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Increase Output Only in the Short Run

Policy makers can stimulate aggregate demand, for example, by pursuing expansionary monetary and fiscal policies (see Chapters 10 and 11, respectively). An increase in aggregate demand typically leads to an increase in output in the short run, because prices haven’t yet had a chance to adjust fully to the increase in demand.

In the long run, however, output is determined solely by the supply side of the economy (see the earlier section ‘Factoring in Factors of Production’). Therefore, unless fiscal/monetary policy increases the quantity or quality of factors of production or leads to technological progress, it has no impact on output.

This fact means that governments should avoid trying to grow the economy by increasing aggregate demand – it only leads to inflation. Instead, they should direct their efforts towards the supply side of the economy.


Accepting that Financial Crises Are Certain and Impossible to Predict

Financial crises happen with surprising regularity (although the global crisis of 2007–08 was unusual in its severity, reach and persistence). Macroeconomists have known this for some time – asset prices have fat tails: that is, they suffer large falls relatively frequently.

Macroeconomists still don’t fully understand the causes of financial crises (it’s an active area of research), but they do know that the financial system is always vulnerable to a sudden loss of confidence for the following reasons:

Banks keep only a small fraction of deposits in reserve in case

customers want to withdraw their funds. In normal times this approach is fine, because only a small proportion of a bank’s deposits are withdrawn on any given day. But a loss of confidence in a bank (for whatever reason) can lead to a bank-run, where large numbers of

depositors want to withdraw. Therefore, any bank, no matter how healthy, can fail if people believe it may be in trouble.


Banks are so interconnected that trouble at one can easily spread to


many others. This problem is known as contagion.


Crises are also very difficult, if not impossible, to predict. The reason is the Efficient Market Hypothesis, which says that the current price of a financial asset already contains within it all publicly known information. Thus, if predicting a financial crisis occurring (say) next year were possible, it would cause a crisis right now, as people would rush to sell their financial assets.


Chapters 14 to 16 contain all you want (or fear you need) to know about financial crises.