During the 1960′s, Keynesian fiscal policies (also known as “demand management” policies, since the government uses them to manage the level of aggregate demand in the economy) were regarded as unquestionably beneficial to the economy. In the early 1960′s, US President John F. Kennedy had implemented major tax cuts. These lifted the North American economy out of a recession and can be given credit for the economic boom that lasted through most of the 1960′s.
Following the late 1960′s, however, experience with government monetary and fiscal policy was much less satisfactory. Excessive stimulation in the late 1960′s led to rapid inflation; in response, strong anti-inflation policies were applied, causing unemployment to rise to high levels. Again in the 1970′s, excessive stimulation generated very severe inflation, followed by anti-inflation policies and a recession.
Clearly, something had gone wrong: the monetary and fiscal policies that were supposed to be used to reduce economic instability were being applied in a stop-go fashion that actually created instability, wrenching the economy from rapid inflation to recession and back again. The bad economic effects of these policy decisions have led some economists to argue that the government should not actively manage the level of demand in the economy with its monetary and fiscal policies. They believe that, due to political pressures and the problems of time lags, government attempts at “demand management” tend to become mismanagement, with negative effects on economic stability and prosperity.
To remedy this, these economists argue, governments should be required to followed fixed rules for monetary and fiscal policy rather than be allowed to adjust the federal budget and rate of growth of the money supply as they see fit. In particular, it is sometimes argued, the money supply as they see fit. In particular, it is sometimes argued, the money supply should be allowed to grow at only a certain rate and the federal budget should always be balanced. Such rules, these people say, would prevent governments from making major errors in economic policy, especially in the direction of overstimulation.
Other economists disagree with this view. They point out that our economic system has a history of instability, culminating in the Great Depression of the 1930′s. They argue that the government can and should actively intervene in the economy growth has been more rapid and recessions less frequent and less severe than before. They also argue that, if mistakes were made in the use of these policies, we should learn from those mistakes rather than abandon the policies altogether in the blind hope that it will all work out somehow.
Which view is correct? There seem to be elements of truth in both views. Management of demand by government can have either beneficial or negative effects on economic stability and prosperity, depending on whether the policies are used with the proper timing and strength. For such policies to benefit the economy, the government must base its decisions on the effectiveness of policies intended to stimulate the Canadian economy. Because so much (about 30 percent) of the respending effect of the multiplier is drained off by imports when Canadian authorities inject additional demand into the economy, the multiplier effect is quite small. As a result, policies intended to stimulate the Canadian economy have less impact on output and employment in Canada than Canadian authorities would like.
In summary, the heavy exposure of the Canadian economy to international economic forces creates special difficulties for Canadian economic policy-makers. In particular, the importance of exports and of foreign capital inflows places significant limitations on Canadian authorities in deciding monetary and fiscal policies, forcing them to consider not only domestic Canadian problems, but also international factors, when formulating policies.
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