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Chapter 8: The determination of national income and the role of fiscal policy

Chapter Introduction

In this chapter we look at the determination of national income, employment and inflation in the short run: i.e. over a period of up to two years.

The analysis is based on the theory developed by John Maynard Keynes in the 1930s (see Box 8.1), a theory that has had a profound influence on economics. Keynes argued that, without government intervention to steer the economy, countries could lurch from unsustainable growth to deep and prolonged recessions.

In Sections 8.1–8.4 we examine what determines the level of national out-put and why it tends to fluctuate (i.e. why there is a business cycle). As we shall see, Keynes placed particular emphasis on the role of aggregate demand (total spending) in determining economic activity. If aggregate demand is too low, there will be a recession with high unemployment. On the other hand, if aggregate demand is too high, there will be inflation.

Then in the remainder of the chapter (Sections 8.5 and 8.6), we look at the use of government policy to control aggregate demand so as to stabilise the level of output and keep the economy as close as possible to full employment. We focus on the use of fiscal policy. This involves altering taxes and/or government spending.

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