Macroeconomic Environment of Business - Limitations of the Use of Fiscal Policies - Case Study Example

Macroeconomic Environment of Business - Limitations of the Use of Fiscal Policies Table of Contents Macroeconomic Environment of Business - Limitations of the Use of Fiscal Policies 1 Table of Contents 1 1. 2008-2009 recession: 2 2. Role of fiscal policy to recover from recession: 3 3. Limitations of the use of fiscal policies: 3 4. Usage of conventional monetary policy to recover from recession: 4 5. Limitations of the use of conventional monetary policy: 5 6. Monetary policies used and how it was supposed to work: 7 7. Supply side policies and contribution in resolving economic problems: 9 8. Differences between the Euro zone, the UK and the USA in macroeconomic policies adopted to encourage recovery from the recession: 11 9. Is there any evidence of different outcomes from these differences in policy? 12 10. Assess the political pressures and social issues that might constrain governments from following a purely ‘economic solution’ to their most pressing macroeconomic problems. 13 Reference 13 Bibliography 15 1. 2008-2009 recession: The global financial crisis stretched its hands on what is regarded in today’s world as “Great recession” which had serious impacts on the economic stability and fortunes of many countries. The old proverbial statement of the globe crashes when the US economy seems a downturn became once again true. The year 2009 is regarded as the year as the year of the calamitous turn around on the boom years of 2002-2007. Causes of the Recession: The foremost causes which lead to the recession were the geopolitical disturbances which lead to the stagnation of oil prices along with turbulence in the stock market. There was a continuous rise in the staple food prices resulting in runaway inflation close to 6%. The European central bank raised the interest rates and increase in the unemployment rate at the end of 2008 due to the outbreak of housing bubble all contributed in resulting the recession. Effects of the recession: The US GDP showed its slowdown in 2008 (Suffolk County Council, 2008, pp.3-4) and fell further in 2009, first time since 1950s. There was a decline in capital investment sine the last quarter of 2006 and the pace of residential investment dropped down in the first part of 2009. The US domestic demand is a record breaker dropping down to 2.6% per quarter. Unemployment also started to rise and matched with that of early 1980s. 2. Role of fiscal policy to recover from recession: Fiscal stimulus played an important role in nullifying recessionary spiral. However the impact seems to be much less for economies with higher amounts of public debt. In order to support the aggregate demand the need of the time is aggressive monetary policies. Economists who follow Keynes argues that an expansionary fiscal policy act as an incentive to increase aggregate demand. Even such a step may not be fruitful because steady economic growth depends on health of the economy. Restoring the confidence of the financial sector is the key to move out from such a situation (International Monetary Fund, 2009, pp. 111-112). The need is to analyse the effects of discretionary policies on the severity of recessions. Expansionary fiscal policy acts to increase demand either directly through increase in government expenditure or indirectly through a reduction in tax which will stimulate the private consumption to take effect. 3. Limitations of the use of fiscal policies: There may be a few limitations of using fiscal policy in order to increase aggregate demand. The time factor is to be taken into account. The government needs time to change its fiscal plans and once implemented the new plan will take time to increase the aggregate demand. Again increasing aggregate demand may be the factor in causing crowding out which means that if government tries to increase its expenditure then it may lead to fall in private sector spending. The reason being the government borrows from the private sector to finance its expenditure (Auerbach, 2005, p.8). Many economists rule out this theory as they believe that the government will use the unemployed resources. Again reduction in public spending may have adverse effects on public services. One of the important limitations is the magnitude of appropriate multiplier. The magnitude plays a significant role in changes in injections. 4. Usage of conventional monetary policy to recover from recession: Monetary have its effect on the interest rate and money supply. Expansionary monetary policy consists of the actions taken by central bank like the U.S. Federal Reserve. The actions include reducing the short term interest rates, purchase of government bonds and lowering the level of bank’s reserve requirements. The purchase of government bonds will result in flow of money into the economy and the lower reserve requirements will provide banks cash flow as they now require to hold fewer reserves for deposits. The reduction in the cost of borrowing will reduce the rate of home mortgages which will raise the disposable income. Monetary policy focussed on inflation target and adjusted interest rates to try to achieve the target. The early 1990s recession pushed all three economies into significant deficits, which subsequent 1990s boom helped reduce (Figure 5). The US and UK government’s were in surplus at the end of this period UK 1999-2001, US 1999-2000. The Eurozone governments remained in deficit as a whole. The slowdown in growth after 2000 led to deteriorating financial positions, higher growth then reduced but did not eliminate the deficits. So governments entered the financial crisis already in deficit, the economic recession that followed led to a very rapid deterioration in government finances that was much worse in the UK and the USA, than in the Eurozone. In 2009 the UK government deficit was 11.4%, the USA 11.5% and the Eurozone 6.4%. These are large deficits, subsequent growth should reduce but not eliminate them so without further policy measures the deficit would remain substantial. The cyclically adjusted current government balance is called the structural balance, the structural deficit for the UK was estimated at 5.5% for 2009-10 (OBR, 2011, p. 176). 5. Limitations of the use of conventional monetary policy: There are certain limitations which may act as hindrance to combat recession. In spite of lower interest rates people may not be inclined in investment or expenditure because of lack of confidence. In a recession, households who are worried about their jobs and incomes and businesses who are worried about trading conditions are not likely to want to increase their borrowing. This situation is exacerbated in the UK and the US by the very high levels of debt of households and by the fact that business debts have substantially increased (Figure 13-14). In a situation of financial crunch banks may not have sufficient flow of funds to lend out and so even if the central banks cut the interest rates it is difficult to get a loan. The commercial banks may not pass on the base rate to its customers. Expansionary monetary policy boosts consumer spending but in situation of recession the reduction in export may nullify the advantages of increase in consumer spending. Since nominal interest rates cannot normally be negative, when interest rates get close to zero it is difficult to ease monetary policy further. In Germany the situation is very different household debts have fallen and business debts have only risen marginally (Figure 12). Data Source: (Economics. help, 2012) 6. Monetary policies used and how it was supposed to work: The first step that the Fed used to was to reduce the federal funds rate. It raised the interest rate to 5.25% in June, 2006 and remained stable till the first cut in September, 2007. It continued to cut the rates until the Lehman crisis. The financial sector was exceptionally fragile in late 2008. Central banks resorted to some ‘unconventional’ policies to provide support to the financial sector. The measures included providing liquidity in the economy for longer periods, accepting a broader range of assts as collateral, increasing the number of financial institutions which have access to central banks liquidity. They changed the composition of the central bank balance sheet by purchasing long duration government bonds and private sector assts in order to provide liquidity and reduce the borrowing costs. The nominal spending was raised what is known as the ‘quantitative easing’. But many of these policies were associated with large balance sheet expansions. The following figure shows the relationship between expectations and unconventional monetary policy. The circles represent a country while the size of each circle represents the increase in central bank’s balance sheet February to December 2009. These data has been chosen because it refers to the period when there was dramatic decline in expectations between inflation and growth. March, 2009 can be taken as the break point as roughly corresponds to the introduction of asset purchasing programs of the central bank. The interpretation is that countries that implemented huge central bank balance sheet expansions tended to experience larger expectations reversals. Private lending has been constrained not only by demand but also by supply, as banks try to restore their capital and their liquid reserves in response to bad debts incurred during the crisis and by the increased reserve requirements that are being imposed on them to avoid future crises. Quantitative easing also has the effect of making government borrowing cheaper and easier, which is one of the reasons why the USA and the UK have been able to fund enormous government deficits at very low rates of interest. The Bank of England’s analysis (Joyce et al, 2011, p.210) suggests that QE has raised GDP by 1.5 to 2% and inflation by 0.75 to 1.5% but there is considerable debate about the effectiveness of QE (Macintosh, 2011, Wolf, 2011). Data Source: (Carvalho, Eusepi and Grisse, 2011, p. 12) 7. Supply side policies and contribution in resolving economic problems: Supply side policies are the measures taken by the government to increase the productivity and shift the LRAS to the right. They include policies that reduce blockages to the free market or overcome the market failure. An example of supply side policies is education and training. Supply side policies can help to reduce unemployment. If the government reduces minimum wages this would cause a reduction in classical unemployment. The policy may be ineffective if the firms have monopsony power or if unemployment is caused by demand deficiency. Some successful supply side policies can contribute in increasing competitiveness leading to increase in exports and BOP current account. They need some time to take effect and cannot contribute immediately in stopping increasing imports. It can help in reducing inflation rate but remains ineffective in keeping the demand pull inflation at a lower rate (Economics. help, 2012). 8. Differences between the Euro zone, the UK and the USA in macroeconomic policies adopted to encourage recovery from the recession: The Dodd-Frank Wall Street reform and Consumer Protection Act was passed under the presidential of Barrack Obama in U.S. The proposals included consolidation of regulatory agencies and innovation of a new oversight council for the evaluation of systematic risk. Consumer protection involves a new consumer protection and a uniform standard for the ‘plain vanilla’ products strengthening the investor’s interest. Various measures were also aimed at increasing the international standard and strengthening regulation of credit rating. To ease out the effect of recession the Federal government has taken a banking bailout package along with another stimulus package called the ‘Growth Acceleration Act’. The measures were only of three categories namely measures to create employment, measures to secure employment and other measures. The European commission proposed a $256 billion Recovery plan. The plan is comprised of two parts. Each member of the EU was asked to contribute 1.5% of their GDP in order to boost demand and secondly members were requested to diver investments in eco-friendly technologies, which would create jobs and save resources (Congressional Research Service, 2009, pp.3-4). In the Eurozone emphasis has shifted to reducing deficits and reducing debt. In order to try to ensure that offsetting private sector Eurozone members are also encouraged to “pursue structural reforms, notably in the area of pensions, the labour market, product markets and the services sector to ensure the long-term sustainability of public finances and to increase the growth potential of the economy and its resilience to crises” (Eurogroup, 2010, p. 3). These measures were tightened further in 2011 “Fiscal policies for 2012 should aim to restore confidence by bringing debt trends back onto a sustainable path and ensuring that deficits are brought back below 3% of GDP in the timeframe agreed upon by the Council. This requires in most cases an annual structural adjustment well above 0.5% of GDP.” (European Council, 2011a, p.2) The Eurozone crisis has meant that deep budget cuts are being made in Portugal, Ireland, Italy, Greece, Spain (the PIIGS) or at least recommended, but countries with more sustainable fiscal positions such as Germany are also cutting their government deficits (European Council, 2011b). 9. Is there any evidence of different outcomes from these differences in policy?  As far as Germany is concerned, they criticized the steps for not moving aggressively in order to combat the effects of recession. Their response changed dramatically and the steps favoured a policy that is more closely tailored by the German economy. The Dodd-Frank Act imposes stringent requirements of capital for the financial institutions. It is required that the council make recommendations to the Federal Reserve regarding setting up for leverage, liquidity or contingent capital. The US economy now is in a stable state but the corporate governance must be made legal as some small companies are against it but they have their effects in the economy. There is lack of coalition between the Eurozone countries namely Greece. The Eurozone countries namely Italy, Portugal are still realising the effects of recession and as a result the global economy is suffering (Morrison and Foerster, n.d., pp.22-23). 10. Assess the political pressures and social issues that might constrain governments from following a purely ‘economic solution’ to their most pressing macroeconomic problems. Often the best intensions of the government might result dismal as the eventual outcome may be in deepening of the market failure. The failure of the government may range from trivial when the intervention is ineffective but there might be cases when intervention leads to the rise of a more serious problem. Some of the causes are political self interest, policy myopia, regulatory capture, Government intervention and disincentive effects, Government intervention and evasion, Policy decisions based on imperfect information, Costs of administration and enforcement. Reference Economics. help, 2012. Expansionary Monetary Policy. [Online]. Available at: http://www.economicshelp.org/blog/4886/monetary-policy/expansionary-monetary-policy/. [Accessed: 1st March, 2012]. Carvalho, C., Eusepi, S., and Grisse, C., 2011. Unconventional policies during the crisis and expectations of inflation and growth: a cross‐country analysis. [Pdf]. Available at: http://www.newyorkfed.org/research/economists/eusepi/unconventional_policies.pdf. [Accessed: 1st March, 2012]. Economics. help, 2012. Discuss the importance of supply side policies in improving the performance of the UK economy?. [Online]. Available at: http://www.economicshelp.org/macroeconomics/as-essays/supply-side-policies-improving-econ.html. [Accessed: 1st March, 2012]. Congressional Research Service, 2009. The Financial Crisis: Impact on and Response by The European Union. [Pdf]. Available at: http://www.fas.org/sgp/crs/misc/R40415.pdf. [Accessed: 1st March, 2012]. Morrison and Foerster, No Date. THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT, OR DODD-FRANK ACT, REPRESENTS THE MOST COMPREHENSIVE FINANCIAL REGULATORY REFORM MEASURES TAKEN SINCE THE GREAT DEPRESSION. [Pdf]. Available at: http://www.mofo.com/files/Uploads/Images/SummaryDoddFrankAct.pdf. [Accessed: 1st March, 2012]. Suffolk County Council, 2008. The Effects of Recession and Those Most at Risk. [Pdf]. Available at: http://www.suffolk.gov.uk/NR/rdonlyres/320E5D8B-E2DE-49E8-976A-95C87541D97F/0/EffectsoftheRecessionandThosemostatRisk.pdf. [Accessed: 1st March, 2012]. International Monetary Fund, 2009. From recession to recovery: How soon and How strong? [Pdf]. Available at: http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/c3.pdf. [Accessed: 1st March, 2012]. Auerbach, A., 2005. The Effectiveness of Fiscal Policy as Stabilization Policy. [Pdf]. Available at: http://elsa.berkeley.edu/~auerbach/effective.pdf. [Accessed: 1st March, 2012]. Bibliography Baumal, W., Blinder, A., 2011. Economics: Principles and Policy. 12th ed. Canada: Cengage Learning. Gwartney, J., Stroup, R., Sobel, R., and MacPherson, D., 2008. Economics: Private and Public Choice. 12th ed. Canada: Cengage Learning.   Read More