Economic Portfolio - Economic Growth - Coursework Example

Usually, the monetary policy is executed by the central bank, through its capacity as the financial sector regulator or through its participation in the government deficit financing and open market operation. Both the Fiscal and monetary policies are very essential not only due to their macroeconomic implications but also they are important in determining the policy remit of the state, direction and level of economic transfers which intern influence the overall distribution of wealth and income as well as the level of economic activities and the structure of employment.

According to Keynesian macroeconomics, The monetary and physical policies can be relied upon in controlling aggregate demand (AD) and even the change in general price level of commodities i.e. inflation rate, with the view of stabilizing price and achieving full employment. Generally in a closed economy, aggregate demand (AD) include three major elements which are; investment (I) consumption (C) and government spending (G). Where as, for an open economy, AD includes exports (X) and imports (Z) which gives nets export (NX) as the sum of the two.

Most probably, C is always a positive function of the disposable (post-tax) income, which is negatively correlated i.e. negative output gap (NOG) with interest rate level. On the other hand the reverse will give a positive output gap (POG). For instance, when consumer’s mortgage and credit becomes so expensive, the disposable income will definitely fall and this will make consumption to decline proportionate to it. In most cases, the AD curve will exhibit a negative slope in the price-output or price-income (P-Y) space; this is due to the fact that, when prices increase, the real money supply (M/P) will decline.

Thus, in order to restore the normal equilibriums between money demand and supply, the rate of interest has to rise. Immediately this happens, funds will become very expensive and both I and C decline as shown in diagram 1. Figure 3: Aggregate demand According to this model, it assumes that the economy is operating at a high level of employment or very depressed. Considering the above, the aggregate supply (AS) curve is so parallel to the P-Y space and firms will be willing to supply any amount at the prevailing prices.

This shows that the output gap (income) is determined using the AD curve as shown at point E in figure 2. Figure 2: Aggregate supply and demand. If the economy starts operating at a level bellow capacity, the government must relax it’s monetary or fiscal policy stance i.e. increase the rate of taxation, lower the interest rate or increase expenditures so as to raise I, G or C. This will definitely cause a shift of the AD curve to the right, increasing output level, demand and employment (L) in the economy as shown in figure 3.

Conservatively, if inflation is threatening to take off and unemployment is abnormally low, the government must consider tightening its monetary and fiscal policies. The resulting spending will cut down the higher interest rate or tax rate thus; limiting the existing inflationary pressures as illustrated bellow. Figure 3: Fine-tuning aggregate demand. Incase the government decides to manipulate its monetary and fiscal policy stance completely, and then it must be able to eliminate the economic cycle as well as