Question

The main objective of stabilisation policy is to ensure that output levels are close to the potential while inflation and the current account deficit are kept at acceptable levels. A set of co-ordinated financial management of government resources is required. Baptiste (1980) identifies three schools of thought with respect to the application of financial management within an economy. The Keynesian, Monetarist and New Cambridge schools.

1. Evaluate the Keynesian perspective and the basis of their argument.
2. Similarly examine the Monetarist perception.
3. | Discuss why Monetarists argue that the manner in which the deficit budget is financed is critical.

Answer 1

Macroeconomic Stability is an important aspect of economic growth and a policy objective that governments and economists seek to reinforce , since its important to maintain stability at the aggregate level.

Keynesian approach  argued a practical view to the classical full employment equilibrium assumption of equilibrium, stating that the equilibrium achieved is one of near to full employment equilibrium and not full employment equilibrium in the real sense. The school of thought argued that the near to full employment exists because , there has to be considered a certain amount of unemployment --whether it is voluntary, frictional and so on.   This prevents full employment equilibrium in the actual sense. Keynesian economists believe that 'price mechanism' and automatic adjustments to income and employment levels do not bring about the much need equilibrium in the economy and many a time active and consistent governmental intervention is needed, the output could register a slow growth and the economy could move away fro the full employment level of equilibrium which through governmental policies--both fiscal and monetary ( in association with the central bank of the country ) have to actively pursued in order to bring the economy to (near to ) full employment equilibrium. In case of deficit demand when the economy is operating under full employment level, the government should increase public spending  and resort to a deficit budget to counter the situation. Taxes should be reduced and more disposable income should be made available in the hands of the public which will increase aggregate demand and revive the economy onto its growth path.

  In case of inflation, when the aggregate demand is much higher than the aggregate supply at the full employment level, the government should follow a policy of contracting the expenditure and thereby raise taxes and spend less   as also resort to reducing the current account deficit.

The monetarists believed that the economy is at full employment level and any deviations from this equilibrium will automatically lead to a series of rapid adjustments that will ensure that the equilibrium is regained. The monetarists believed that , the economy would gradually achieve an optimum rate of output , any movement away from this equilibrium will be followed by a process of fast paced changes which are effective enough to revert the economy back to equilibrium position.The aggregate supply is elastic or responsive to increases in aggregate demand up to a certain extent, it later on becomes  inelastic or non responsive since it has reached an optimum limit of utilization of the available resources. Until the aggregate supply or output is able to respond to changes in demand the aggregate price levels rises in tandem with output, and inflation is much lesser

Yet they insist that inflation should be kept under control by the government and should be one of its key goals. They argue that optimal financial management of resources occurs when money supply is regulated and brought under control. Since excess of money supply will automatically accelerate the aggregate demand and will lead to inflationary spiral.

Since 'inflation ' is their main variable that needs to be monitored , any governmental spending resulting in current account deficit would lead to a further rise ion the inflation and the consequences could be well spread over a long period of time thereby hampering the rate of growth.

The are of the opinion that in general the economy is relatively stable , though for periods of destabilization that occurs due to any excess of supply of money which spirals into a downward trend and reverts the growth cycle.

The Cambridge School of thought seeks to explain equilibrium as a process to be achieved with the help of changes that occur in spite of the presence of strong fundamentals or variables that are not easily alterable. It seeks to collaborate the microeconomics aspect to macro economics and there by establish the interdependence of both branches and seek to be as close to realistic picture as possible .

The school believed that money supply , an important macroeconomic variable that can affect the working of n economy and have consequences over long periods of time has to be suitably monitored by effective monetary policies  which have to assertively enforced by the central bank of an economy which wields a great authority on the circulation of money supply in the country. It can effectively employ tools like cash reserve ratio, repo rate and so on to control the lending power and the power of the commercial banks to create credit.

In times of inflation, the reserves to be held by the commercial banks should be increased such that they are discouraged to lend --recklessly, in times of recession or periods of a 'low' in economic activity these banks should be encouraged to lend more and revive the growth cycle.