If savings, tax and imports are greater than government spending, investment and exports, then there is an overall leakage from the national income or output. This is the basic problem for which fiscal and monetary policies have been put into use.
The first option open to the government would be the use of fiscal policy, mentioned earlier, which involves the controlling of government spending, in this case to raise national income to full employment. Favoured by Keynesian economists, the exact type of fiscal policy that governments will most likely use is reflationary fiscal policy, which is used when the economy is in a recession, or as in this case, national income is not at full employment. The way to do this would be to lower taxes, either direct, indirect or both, and raise government spending. The amount that governments need to spend is equal to the deflationary gap (when planned expenditure is less than the full employment level of employment or when unemployment is present in the economy) on the consumption function diagram. This is less than the actual amount needed to take the current level of employment to full employment, but because of the multiplier effect, it is sufficient. The multiplier effect works in such a way that the initial amount spent, depending on the average propensity to consume, which is how much of a raise in income a person will spend on average. If this is a high amount, say 0.9, then a person will spend 90% percent of any increased income, so if there was a $100 million injection into the economy, $90 million of it will be spent. This income eventually is spent and becomes someone else’s income, who will then spend 90% of that amount, which is $81 million. This will continue until nothing is left of that amount, but by that time, so much more than the initial $100 million will have been generated. This government spending would help overturn any leakages from the circular flow.
The deflationary gap and the difference between Ye and Yf is shown here in this diagram:
The deflationary gap is clearly smaller than the gap between Ye and Yf, and the gap is only bridged by spending the amount of the deflationary gap because of the multiplier effect. The actual formula for the multiplier is (change in income)/(change in government spending) or 1/1-MPC. A decrease in direct and indirect taxes will have very similar effects, as it allows consumers to have a greater disposable income.
The manipulation of monetary policy is the other option that is available to the government. This is when the government or central bank of a country will change interest rates or control the supply of money to achieve their aims of stable price levels, a balance of payments equilibrium, high economic growth, and to bring national income to full employment, as in this case. By cutting interest rates, people are encouraged to borrow and therefore spend and invest more, and will have to pay less on returns or mortgages so they will have a greater disposable income. By spending this money, and through the aforementioned multiplier effect, full employment may well be reached. Some economists also believe that increasing the supply of money will increase spending due to the fact that there is more money to spend, but contrary to this argument is that a rise in the supply of money will cause inflation. The supply of money is determined by the formula MV=PT, where M is the money supply, V is the velocity of circulation of the money, P is the price level and T is the number of transactions. MV and PT both essentially equal output, so if we assume that V and T are constant, a rise in M will result in a rise in P as well as vice versa. The way to control the money supply would have been to stop banks from lending money, so that in effect, consumers and investors have no money to spend. Governments would have don’t this by forcing banks to buy certain government securities through the central bank and therefore leave banks with no money to lend. In the case or Argentina, they simply did not open banks so no money could be borrowed and spent. Nowadays, they merely change interest rates to influence consumers and investors.
The fundamental difference which exists between Keynesian economists and monetarists is that the monetarists believe that the economy is self correcting, that a change in the interest rates will lead to greater spending without the help of the government, whereas Keynesian economists believe it is the duty of governments to stimulate spending in the economy by pouring money into the economy, and with the help of the multiplier, reduce any unemployment.
There are still several factors that limit the use of fiscal and monetary policies though, such as an inability to keep the economy at a constant level. When the problems of high unemployment and low economic growth are solved, the problems of inflation and balance of payments deficits arose, and as soon as these issues were solved, the other pair becomes evident. This cycle means that there will usually never be a economy in a stable, immobile state.
