Governments main objectives of using this type of policies is to stimulate the aggregate demand, reduce inflation, improve a recession, collection of revenue to provide public goods, improve on market failure caused by externalities or even steer the economy to achieve higher growth.
as earlier discussed the main objectives of government policies is to improve on a recession, depression, inflation, solve on market failure caused by positive and negative externalities, collection of government revenue to provide public goods and to stimulate aggregate demand. These policies will also be used in case of a boom in the economy. The policies can be used together to improve a situation or one of them used.
Inflation can be defined as the consistent rise in the general prices of goods for a fairly long period of time, the most used indicator of inflation is the consumer price index. Inflation is caused by demand push according to Keynes; he argued that inflation will exist when the aggregate demand exceeds aggregate supply. The excess demand can be from the real sector or the monetary sector.
TheThe real sector consist of the model that is used to calculate the national output, Y = consumption + government spending + investment + exports - imports. if marginal propensity to consume increases then aggregate demand will increase leading to inflation, if government spending increases then this will increase aggregate demand also if the level of investment increases this will cause an increase in the aggregate demand and finally if the exports increase then aggregate demand increases and this can be seen when there is a boom caused by increased exports. The monetary sector means that in the case where the money supply in an economy increases this triggers inflation.
The other type of inflation is the cost push inflation caused by an increase in the cost of production due to an increase in the price levels of Raw materials. an increase in the cost of production will lead to high unit cost of production, these high prices are passed on to the consumers, therefore their real wages decreases and trade unions come in and fight for high wages and if they are granted higher wages the cost of production further increases.
In case of inflation the government will come in and interfere with the economy, in this case the government will simply use monetary policies to improve the situation, they will increase the rate of interests so that the amount of money in circulation in the economy reduces, the government will also improve this by reducing the supply of money in the economy, this can be achieved through increasing the bank reserve ratio held by a central bank.
This can be diagrammatically shown as follows;
When inflation increases from 0 to 1 then the real GDP falls from y0 to y1, if y0 was the potential output then the economy is operating below potential output, to improve this government will reduce the interest rates the interest rates