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You are required to write an essay independently on an assignment.

To demonstrate an understanding of the relevant economic ideas or theories
To apply economic theory to real world situations
To write a structured, coherent and fluent essay 

The objective of this Unit is explain the ways in which the Government can exert an impact on the economy’s equilibrium output via changes in fiscal policy, which in turn will affect the budgetary position of the state.

Whether an indispensable evil or a necessary lever against unfettered market forces, the Government sector exerts a strong impact on the economy, often in a unique way:

Why do we call mechanisms such as proportional income taxes and the welfare system automatic stabilizers? Choose one of these mechanisms and explain carefully how and why it affects fluctuations in output.

Aims and Objectives of the Assignment

In relation to the letter the letter received from the prime minister, the success of the forthcoming budget is crucial to the next general election. This budget is a reflection of the direct outcome of the economic, social, and political policies that the government stands for. The objectives and importance of preparing this budget is evident in the fact it will play a big part in the reallocation of resources to reduce differences in income and wealth distribution to ensure economic stability within the country. Economic stability directly translates to economic growth.

The plays a number of roles in ensuring the stability of the economy. These include supporting the economy by providing goods and services that the private sector cannot provide. Such include the funding of education and construction of infrastructure. In addition, the government regulates how businesses are run so as to ensure that there is fair play and that businesses serve the interest of the general population. The government takes responsibility of ensuring that business cycles are kept under control by setting taxes and interest rates, and controlling the money supply that is circulating within the economy. It can also control the economy by affecting the amount of money it spends through the fiscal policy. In addition to this, the government as it plays the part of the lender of the last resort, it also acts as the employer of the last resort. In short, the government helps to take care of market failures in situations where the private sector is not able to satisfy fully the needs of the society.

Through formation of a solid budgetary policy, the government will be able to identify and reallocate resources to the sectors that have otherwise been disadvantaged. This is in line with the economic and social goals of the country. To be able to do this efficiently, the government will have to encourage investment by offering tax reliefs and subsidies to producers. Another way of encouraging production is to produce goods and services that the private sector does not have interest. Provision of infrastructure and utilities like supply of energy.

To achieve economic stability, the budget can be used to take care of business cycles of inflation and deflation (Mankiw, 2007). This control of the business fluctuations will help in maintaining the stability of prices in the economy. Such fluctuations are usually brought about by inequalities in income and wealth. The budget will influence how income and wealth is distributed by taxation and resource allocation to raise the standard of living for the poor and take care of the general welfare of the population. The levels of taxation that work at the present are to bring in revenue of which is approximately 20% of the national income. This represents a good reception of the revenue. Economic stability will ensure that there is economic growth because the population will be able to save and invest. In this way, the government is able to mobilise investment in the public sector and in the long run reduce the economic disparities in the different regions of the economy by setting up production units in the economically backwards regions.

The Rôle of the Government sector in the economy

As we can see, government activity is important in influencing the trends in the economy.  However, this activity is limited to direct expenditure on goods and services. The budget estimates indicate that the government programs that are in place could end up costing 4 million on goods and services. The government can also raise revenue through taxation of incomes (20 % of the national income). In this case, it will be prudent to increase government expenditure rather than increasing taxes on income. During this period, it is evident that firms are in their final phase of financial years. This means that the firms are cutting down on investment. This can translate to the fact that there will be reduced consumer spending. In relation to this, increasing government spending can lead to a multiplier effect.

Through government spending, more jobs can be created which will lead to an increase in income earned by the population and an increase in aggregate demand. The government will gain in this through taxation of income earned and this will be the best way to avoid a budget deficit. This can eventually cause a bigger final rise in the GDP as it is evidenced in the Keynesian Cross. There is direct relationship between government spending and national income times a multiplier. Whenever there is a change in government spending, the national income will change by the same amount times the multiplier. Reduced capital investment by the private sector will have little or no significance in the current levels of the GDP. The gross domestic fixed capital is forecast to be at 4 million.

Productivity is one of the major concerns in the economy in the economy now and it increased last year so that if the economy was to attain full employment, the GDP could be at 20 million. Full employment in this case refers to a situation in the economy where output is at its highest level, unemployment is at its most efficient level and inflation is stagnant. To achieve full employment GDP, unemployment and inflation should be at equilibrium. Whenever unemployment reduces, inflation should go up. However, in the real sense, economies are not usually like that.

Full employment in an economy will always create a conflict of policies with balance of payments. Full employment always has a direct relationship with a balance of payments deficit (Mankiw, 2007). The problem that arises in this situation is either to create an internal balance or an external balance. By the government raising its expenditure, it increases employment. This will in turn increase the demand for imports and create a disequilibrium in the balance of payments. This disequilibrium has posed a problem for many countries. The challenge is to maintain a situation of full employment and internal balance while in the same time keeping the external balance in equilibrium.

According to the Keynesian model, whenever an economy is at full employment, it does not necessarily mean that there exists an external equilibrium within that economy. To achieve the two objectives of full employment and external equilibrium, we need to implement two policies. These are fiscal policy, which will take care of and ensure full employment of resources, and commercial policy, which will be used to attain a state of external equilibrium.


 Devaluation is necessary to achieve external equilibrium and improving the situation of the balance of payments in this case. Devaluation decreases exports while at the same time increasing imports. Nevertheless, devaluation coupled with increasing government expenditure may not work to the grater benefit. Careful and good timing is needed to use devaluation as a switch in combination with monetary and fiscal policies to the country maintains a state of internal and external balances. The situation in the international market is favourable as the international monetary crisis has taken care of the growth in the world trade. It is estimated that exports will not go beyond 2 million. Imports on the hand are estimated to be approximately 20% of the gross domestic product.

Government policy is very important in ensuring that we achieve full employment. The National Institute has forecast increasing unemployment rates and therefore there is need to change government policies to ensure that we produce full employment next year. There are a number of policies that can be used to achieve full employment apart from increasing government expenditure. These include the decision concerning the growth of jobs in the following year. We will need to consider the pace and scale at which we will raise the interest rates because this decision can end up slowing the economy by weakening the growth of jobs and wages.

The government also needs to create a program that targets employment. To ensure that there is full employment in the economy, we need to come up with policies that will directly create jobs in the areas where unemployment rates are highest. The best way to do this through public and non-profit employment programs that will attract a huge number of employees.

Considering all these factors, fiscal policy will be the best economic solution for the problem of unemployment. As we have seen, fiscal policy involves increasing government expenditure or reducing net taxes. We have also observed that increasing public investment has other indirect advantages. However, in this case, the main effect of fiscal policy is the effect that it has on improving aggregate demand. Many people may argue that expansionary fiscal policy may end up reducing spending by the private sector.

Aggregate demand mentioned above means total demand of the goods and services in the economy. Aggregate demand measures how well the economy is doing as well as how much the economy has grown. Government spending and taxation measures through its fiscal policy will influence the income that the households earn through employment of the embers of the households. This in turn will affect how the consumers spend and invest.

Aggregate demand is a measure of the demand for the total goods and services produced within the country (Mankiw, 2007). Aggregate demand (AD), is given by a combination of the total consumer spending, total investment by both the private and the public sectors, government spending, and the net exports, which is given by total exports less total imports.

This is represented in the equation given below:


AD = C + I + G + NX ; where  C is the consumer spending, I is investment, G is the government expenditure, and NX is the net exports.

Expans ionary fiscal policy will determine government spending on areas like improving the infrastructure, advancing education, and offering unemployment benefits. Keynesian economics assures that the programs mentioned will ensure that aggregate demand does not shift negatively. Through these programs, the aggregate demand is made stable by good employment rates.

Open market operations (OMOs) refer to any sales or purchase of securities by the government and sometimes commercial papers as a way of controlling the supply of money in the economy. Open market operations are also used in stabilizing the prices of government securities. This objective sometimes clashes with the policies created by the central banking authority in controlling credit levels in the money market. Government securities that are used in the open market operations include Treasury bonds and notes, and treasury bills.

Open market operations (OMOs) are basically either expansionary or contractionary in nature. In the expansionary scheme, the OMO tries to increase the money supply and reduce the interest rates to promote growth in the economy. The central banking authority increases the supply of money in the market through purchasing securities from commercial banks. The funds acquired by the banks from the sale will be given to individuals and businesses as loans. More money being available in the market for lending tends to pull down the rates on these loans, which in turn more borrowers to afford cheaper capital. The easy access to capital will lead to greater investment and stimulate the overall growth of the economy.

Employment within the economy will determine the level of consumption indirectly (Miranda & Michele, 2015). According to Keynes, the Keynesian Consumption Function (KCF) is given by, C = Ca + cYd. Ca refers to autonomous consumption and it assumes a figure greater than zero. c is the marginal propensity to consume (MPC). Yd is the disposable income. This disposable income determines the level of consumption within the economy and consumption drives the economy. Disposable income is the income that remains available for the consumers to spend after they have paid taxes and received transfer incomes and social welfare funds. The government by adopting the fiscal policy and creating employment in the long run, it is able to increase the purchasing power of the people within the economy. In addition, the government is able to raise taxes and avoid a balance of payment deficit as well as a budgetary deficit.


BLANCHARD, O. (2017). Macroeconomics.

DORNBUSCH, R., & DORNBUSCH, R. (2002). Macroeconomics. Toronto, McGraw-Hill Ryerson.

MANKIW, N. G. (2997). Macroeconomics. New York, Worth Publishers.

FERRARA, M. H., & LAMEAU, M. P. (2015). Employment.

HANSEN, A. H. (2013). Fiscal Policy & Business Cycles. Hoboken, Taylor and Francis.

STIGLITZ, J. E., & ROSENGARD, J. K. (2015). Economics of the public sector.

LANGDANA, F. K. (2016). Macroeconomic Policy: Demystifying Monetary and Fiscal Policy.

OVERTON, G. T. (2010). Foreign policy in an interconnected world. New York, Nova Science Publishers.

HOLLANDER, B. G. (2011). How currency devaluation works. New York, Rosen Pub.

ABEL, A. B., BERNANKE, B., & CROUSHORE, D. D. (2017). Macroeconomics.

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SMITH, STEVE. (2003). Labour Economics. Taylor & Francis.

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