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Fiscal PolicyThe Keynesian theory of macro instability is a mandate for government intervention in an economy. From the perspective of a Keynesian, too little AD causes unemployment; to much AD causes inflation. Since the market won’t correct these imbalances, the government must. Keynes concluded that the government must intervene to manage the level of AD. This implies increasing the AD when it is deficient and decreasing AD when it is excessive. These can be achieved by manipulating government expenditure and revenue (taxes) which are the two basic tools of fiscal policy.
By definition, fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. Or the use of government budget to influence economic activity. It works principally through shifts of the AD curve.Through taxation and public expenditure – the two major instruments of fiscal policy, the federal government has a great deal of power over AD. Government can alter AD for instance by a.Purchasing more or fewer goods and servicesb.Raising or lowering taxesc. Changing the level of transfer payments.
Effect of Increased Government SpendingOne of the simplest ways to shift AD is to increase G. As government buys mores goods and services, the increased spending would add directly to AD, causing a rightward shift of the AD curve. Thus increases government spending is a form of fiscal stimulus.The Multiplier EffectWhen the government buys more, it create additional income for market participants. As the recipients of the additional income spend and re-spend the income, it creates a multiplier effect.Suppose G increases by N150 billion, what will be the change in spending if the MPC is 0.80?Total change in spending = multiplier * New Spending Injection= 5 * 150 billion= N750 billion
The multiplier effects thus makes changes in G a powerful policy lever. But it also increases the risk of error. Whereas too little fiscal stimulus can leave the economy in a recession, too much can rapidly lead to excessive spending and inflation.To determine the right amount of fiscal stimulus, is to be able to tell the direction of AD which will help determine the required increase in G which will lead the economy to full employment at stable prices. This can be done as shown.