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What problems may a government face in trying to fine tune the economy towards full employment?

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Introduction

A government uses demand management policies to raise the level of national income to full employment. Assuming an open economy with a government sector, analyse the policy options open to the government. What problems may a government face in trying to fine tune the economy towards full employment? When governments use demand management policies to raise the level of national income to full employment, it will usually involve the increase of government spending within the economy. Demand management policies are used when firms do not invest enough to create sufficient demand or if consumers do not spend enough to increase demand, thus a government have to step in and stimulate spending by using fiscal and monetary policy which is basically the manipulation of government spending to produce the desired effects, and involves different methods, as well as the deliberate manipulation of interest rates. Since we are dealing with an open economy with a private sector and imports and exports, the problems that face the government when this policy is put into practice are far ranging and in some cases, become long term problems, such as continual budget deficits. ...read more.

Middle

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. ...read more.

Conclusion

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. ...read more.

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