6 The aggregate demand model with government and fiscal policy

The previous sections introduced some of the arguments made by Keynes as to why capitalist economies can become stuck in positions of high unemployment. Though there may be a quite stable relationship between income and consumption, private investment can languish at levels that are insufficient for full employment. The government may choose to fill the gap: an active state sector for Keynes can iron out the vagaries of volatile private investment spending. For the macroeconomy, the key problem is the failure to reach full employment owing to a shortfall in aggregate demand, and the component of aggregate demand that is most frequently insufficient is investment demand.

This section introduces some of the policy tools that are available to a government department responsible for coordinating public finance – in the UK called Her Majesty’s (HM) Treasury. The Treasury is the coordinating body that allocates government spending (for transport, health, education, defence, and so on) and oversees the collection of taxes (such as Income Tax, Value Added Tax (VAT) and excise duty on petrol). When the government uses these spending and revenue raising activities to stabilise the economy, this comes under the purview of fiscal policy, which is the main focus of this section.

It should be emphasised that the role of fiscal policy is highly contested by economists and policymakers. From a Keynesian perspective, the government has a vital role in stabilising the macroeconomy, because there is no automatic mechanism through which the economy can recover from a recession. For critics of the Keynesian approach, however, the government should leave the private sector alone: it is government intervention that prevents the private sector from bringing about full employment equilibrium. The purpose of this section is to introduce and explore the Keynesian point of view. Some critiques of the Keynesian approach are also explored.

Section 6 introduces government expenditure and shows its full potential Keynesian impact. Not only can government spending generate demand for goods and services that may encourage firms to employ more people, but also its effect on income can be much greater than the initial stimulus. The section then focuses on the more tricky issue of how government spending is financed through taxation. It also considers how the cutting of taxes can help to stimulate aggregate demand. These two dimensions of fiscal policy are brought together in a consideration of fiscal stabilisers. The government can use fiscal policy in a discretionary way to actively intervene in times of crisis; it can also allow what are known as automatic stabilisers to smooth out economic fluctuations. Finally, the section examines a big policy issue that has dominated public policy-making in recent years – the issue of budget deficits.