Macroeconomic Environment of Business - Case Study Example

Macroeconomic Environment of Business Table of Contents 2008-9 recession and its effects on the economy 2 Use of fiscal policy to recover from the recession 2 Limitations on the use of fiscal policy 3 Use of conventional monetary policy to recover from the recession 4 Limitations on the use of conventional monetary policy 4 Use of unconventional monetary policy and the way it works 5 Supply side policies and contributions that make to resolve current economic problems 6 Differences between the Eurozone, the UK and the USA in macroeconomic policies adopted to encourage recovery from the recession 6 Evidences of different outcomes from differences in policies 7 Political pressures and social issues that might constrain governments from following a purely ‘economic solution’ to their most pressing macroeconomic problems 8 Reference 9 Bibliography 10 2008-9 recession and its effects on the economy The 2008-2009 recessions occurred due to a contraction of the business cycle primarily in the US and a consequent slowdown in economic activity in the economy. Some of general areas it impacted upon are GDP, rate of unemployment, utilization of capacity, investment spending, business profits, household income and inflation rates. USA, being the epicentre of the crisis, the economy was largely hit by the sub-prime mortgage market meltdown along with the consequences of the financial crisis and the credit crunch in the economy. The rate of GDP contraction was felt in some of the other advanced and developing economies in the world too. It has led to domestic imbalances in the middle income countries and the open economies ending up into large current account deficits and housing bubbles. Unemployment rates in the OECD countries rose rapidly from 5.7% in 2007 to 8.6% in 2009. This was a rise of 10.1 million individuals without employment in the OECD countries. Unemployment in the US was most massive with similar labor market consequences in Spain, Denmark, Turkey and Slovakia. Some of the worst hit nations were Estonia, Lithuania, Ireland, and Latvia which witnessed dramatic output and labor market contraction (Verick & Islam, 2010, p.20-24). Use of fiscal policy to recover from the recession The most common methods of fiscal policies which could be used responding from the global crisis were a combination of government spending along with tax cuts in order to provide a boost to the slogging economies. According to the Keynesian theory deficit spending could be used by the governments to replace an extent of the demand which was lost due to the recession and prevent further wastage of economies resources due to lack of demand. Governments could have responded by increasing bailouts and injecting money into the financial system in order to allow credit flowing in the economy; cutting down rates of interests in order to encourage investments and borrowing; and finally to allow excess fiscal sending to increase aggregate demand (Verick & Islam, 2010, p.36). This response could be effective in controlling further impacts of the crisis and further economic deterioration and keep workmen in their jobs and help in the creation of new job opportunities for those unemployed. Although this response was likely to control further downturn the effectiveness could vary across economies (The Economic Times, 2008). Limitations on the use of fiscal policy One of the limitations in using fiscal measures during the recessions is the fact that ideally government finances must increase during periods of growth and reduce when the economy contracts or slows down. When economies enter into recession the financial position of the government falls rapidly. Revenues come down along with deteriorating income levels and fall in expenditure and profits. On the other hand expenditure rises when unemployment increases and income levels come down. So in both ways government enters into a deficit where its expenditure rises over and above taxation. Government employed fiscal policies can only be effective when the government debt is reasonable in comparison to the gross domestic product and the deficit is not very high. If this situation is not the case then markets will be uncertain about the government’s ability of repaying its debt and the interest rates on government debt will increase and it will be faced with increasing difficulty in further borrowing (Tatom, 2009, p.14). Use of conventional monetary policy to recover from the recession Conventional monetary policies influences the macroeconomic factors by bringing about changes in the availability of credit and also the price of credit, i.e., interest rates. Monetary policy conventionally acts upon the money supply in the economy and the rates of interest. However researchers admit that monetary policies are less effective in recessions as compared to fiscal policies. Monetary policy tightens the rates of interest and vice versa. Previously controlling money supply was considered to be most important for controlling inflation. However, the focus has now shifted towards targeting inflation rates through adjusted interest rates. However, it is crucial that in monetary policies, real interest rates must be considered rather than nominal interest rates. The reason being that real value of a loan reduces with inflation and generally business revenues and household incomes rise in inflation, consequently the ability to pay a loan also increase s with inflation (Hetzel, 2009, 205-206). Limitations on the use of conventional monetary policy Monetary policies are subject a number of limitations because of which their effectiveness during the recessions are questionable. Inflations other than that occurring in 1990s were relatively low; however, this was not because of the tight monetary policies at that time. Te real rates of interest were particularly low during the same time and the early 2000. These conditions were complementary and accounted for contributory factors in controlling recession through monetary policies during the time. In reality nominal rates of interest cannot be generally negative. When the rate approaches zero, it becomes difficult to ease the monetary policies further. In UK, the Eurozone and the USA, the official rates of interest were very close to zero since the recession. Households were apprehensive about their incomes and jobs and businesses about the trading conditions and averted from borrowing. The condition got exacerbated through increase in household debts and business debts. Such conditions rendered the monetary policies ineffective and unproductive (Cecchetti, 2001, p.15-18). Use of unconventional monetary policy and the way it works Unconventional monetary policies were used when the conventional ones failed. Referred to as quantitative easing, the policy accounts for injecting money into the economy through the purchasing of long term government securities. However, Central Banks were not allowed to the purchase the government debts; however it was mandatory for them to dent to buy these debts from the private holders. This had two implications. Firstly it helped in reducing the long term interest rate in the economy and secondly, increased the supply of money too. The method harnessed private borrowing and lending simultaneously. Private lending was not only constrained by demand but also through supply because banks tried to bring back their capital and liquid reserves arising out of bad debts during the crisis and also by the increased reserve requirements that were being made compulsory on them to avoid crises in the future. Quantitative easing also helped in making government borrowing easier and cheaper, which is why the UK and the USA were able to fund huge government deficits at very low interest rates (Baumeister & Benati, 2010, p.5-7). Supply side policies and contributions that make to resolve current economic problems Supply side policies can have considerable effect on the recessions. One way would be increasing the capital spending on the critical infrastructure of the economy funded by Government of nations. This would be effective in bring forth investment made on hospitals, transport projects, re-constructions, environmental schemes etc. Some project which were both public and private partnered are labour intensive could be helpful in generating a multitier impact on the economy’s demand. Lowering taxation in business, lowering employees’ contributions on national insurance can account for supply side aspects. These are some of the examples of fiscal supply side policies which are helpful in driving up supply side demand in the long run (Palomar College, n.d., p.1-4). Differences between the Eurozone, the UK and the USA in macroeconomic policies adopted to encourage recovery from the recession The US government tried to control the crisis by increasing expenditure even though it had the greatest deficit. It injected $150 billion government expenditure in the American economy. This was in the form of infrastructure projects, education, energy dependence, health and tax reliefs. The US has been trying for another fiscal stimulus even though its first package has not been used completely (Becker, 2010). On the other hand the Eurozone preferred to provide generous unemployment compensations which are significantly different from the US. This is the reason why their unemployment rates were significantly higher than the US. Their labour market policies have been highly criticised by economists. By offsetting the private sector the Euro tried to ensure that they encouraged structural reforms in the areas of labour market and pensions, product markets and services sector in order to ensure long term sustainability of the public finances and improve the potential for growth of the economy and make it more resilient towards such crises. UK tried to implement unconventional monetary policies to control impacts of the crisis by pumping money into the economy through purchases of long term government securities. The US government also tried to implement the same policies. Central Banks were not allowed to purchase government debts directly, rather they would have to do the same though the private holders. These were primarily done to control private lending and borrowing and consequently restored the capital of banks and their liquid reserves which were lost due to bad debts during the crisis (Becker, 2010). Evidences of different outcomes from differences in policies The extensive fiscal stimulus provided by the US government did not attain the employment level which it had targeted. Instead of a forecast reduction in unemployment rate on account of the stimulus the actual decline in the seasonally adjusted unemployment rate has only been half of a percentage point from its summit of 10.2 percent. The fiscal policies undertaken in Eurozone were effective in bringing back debt trends into sustainable paths and reducing deficits considerably. The structural adjustment programs were successful. Unconventional monetary policies undertaken in the US and the UK has been immensely successful in making government borrowing easier and cheaper which accounts for one of the primary ways of funding government deficits at low rates of interests. Political pressures and social issues that might constrain governments from following a purely ‘economic solution’ to their most pressing macroeconomic problems Although it can be said that monetary policies are best set by the independent central banks of nations, fiscal policies continues to be in the hands of politicians. Economists are of the opinion that tax rates are extensively set by political officials and in certain cases there are apprehensions that they can be manipulated by the unelected officials as well. Since monetary policies have a gradual impact on an economy and do not lead to a dramatic or short term solution, economists prefer the use of monetary policies in this regards. In such cases politicians also need a long term vision or horizon for setting monetary policies. On the other hand the short sighted politicians might try to bring about a boom in the economy prior to the elections with the hope that inflations would not rise until after the votes were counted. The Central Banks which is independent and protected from political pressures are more likely to provide greater priority and focus towards price stability. This is the reason why their policies are considered to be more credible by financial marketers. Thus independent central banks can attain lower inflation as well as stable growth (The Economist, 1999). Reference Baumeister, C. & Benati, L. (2010). Unconventional monetary policy and the great recession estimating the impact of a compression in the yield spread at the zero lower bound. Working paper series no 1258 / October 2010. [Pdf]. Available at: http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1258.pdf. [Accessed on March 12, 2012]. Becker, G. (2010). Contrasts Between the US’s and UK’s Post-Recession Policies. [Online]. Available at: http://www.advancingafreesociety.org/2010/11/01/contrasts-between-the-uss-and-uks-post-recession-policies/. [Accessed on March 12, 2012]. Cecchetti, S. G. (2001). The Limits to Monetary Stabilization Policy. Occasional Essays on Current Policy Issues No. 16. [Pdf]. Available at: http://people.brandeis.edu/~cecchett/pdf/cpi16.pdf. [Accessed on March 12, 2012]. Hetzel, R. L. (2009). Monetary Policy in the 2008–2009 Recession. Economic Quarterly—Volume 95, Number 2—Spring 2009—Pages 201–233. [Pdf]. Available at: http://www.richmondfed.org/publications/research/economic_quarterly/2009/spring/pdf/hetzel2.pdf. [Accessed on March 12, 2012]. Palomar College. (No Date). Objectives for Chapter 19: Fiscal Policy and Supply-Side Economics. [Pdf]. Available at: http://www2.palomar.edu/users/llee/101Chapter19-.pdf. [Accessed on March 12, 2012]. Tatom, J. A. (2009). Fiscal policy in recession. Volume 10, Number 2. [Pdf]. Available at: http://www.cesifo-group.de/portal/pls/portal/docs/1/1183057.PDF. [Accessed on March 12, 2012]. The Economic Times. (2010). International business. [Online]. Available at: http://m.economictimes.com/PDAET/articleshow/2920980.cms. [Accessed on March 12, 2012]. The Economist. (1999). Fiscal flexibility. [Online]. Available at: http://www.economist.com/node/262753?story_id=262753. [Accessed on March 12, 2012]. Verick, S. & Islam, I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. IZA Discussion Paper No. 4934 May 2010. [Pdf]. Available at: http://ftp.iza.org/dp4934.pdf. [Accessed on March 12, 2012]. Bibliography Alessi, C. (2012). The Eurozone in Crisis. [Online]. Available at: http://www.cfr.org/eu/eurozone-crisis/p22055. [Accessed on February 27, 2012]. Grauwe, P. D. (2010). Crisis in the Eurozone and how to Deal with It. Katholieke Universiteit Leuven - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR). [Pdf]. 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