Macro-Economic Policy - Essay Example

?Running Head: Macroeconomic Policy Macroeconomic Policy [Institute’s Macro-economic Policy The government carries out the macro-economic policy of a country. Initially, the economic policy might have two broad analyses. In a positive analysis, the economic consequences of a policy are examined. However, it does not deal with the question whether these policies are desirable. On the contrary, normative analysis looks into the question whether the policy should be used. Therefore, there are various disagreements within economists based on personal beliefs and value judgments (Abel & Bernnanke, pp.21, 2005). The macro-economic policy is concerned with carrying out certain economic objectives. These objectives aim to eradicate the main macro-economic problems within an economy. These include unemployment, inflation, and negative balance of payments position, a low rate of economic growth and inequitable distribution of wealth (Stan lake, Grant, pp.499, 1967). Macroeconomics conventionally has two governing views on policy; these are interventionist and laissez-faire (Dixon, pp.2, 2000). The paper, before examining these two views in details, will describe monetary and fiscal policy. Monetary and fiscal policies are the two instruments that the government uses to tackle the amount of expenditure floating in the economy. This is because levels of expenditure highly affect the level of inflation, growth, and unemployment. There are varieties of different forms of government macroeconomic policies. However, the best known and the widely used are fiscal policy and monetary policy. These belong to the demand-side economy that is these policies have the aim of affecting the level of aggregate demand in the economy. In a concise form, aggregate demand of a country is as follows: AD= C+I+G-T+(X-M) Where C=Consumption I=Investment G=Government Expenditure T= Taxes X=Exports M=Imports (Universitip, N.p., N.d). Both fiscal and monetary policies are part of the ‘Keynesian’ school of thought that will be discussed in the paper. These two policies can ‘fine-tune’ various economic problems within the economy such as inflation and output growth (Langdana, pp. 10, 2009). Fiscal policy caters to the two components within the economy i.e. Government expenditure and taxes. If there are inflationary pressures within the economy, then the government can increase the level of direct or indirect taxes, or it might also decrease government spending. Both these measures will reduce inflation in the economy. However, during times of recession, the government can increase the government spending. This will cause an injection of money into the economy, bringing it out of the recession. In addition, during war years, various countries especially USA saw massive increases in government spending, thus increasing the growth rate. The increase in spending was to due to the funding of the war. The level, the timing, and the composition of taxation and government spending can have an important effect on people’s lives (Stan & Grant, pp. 503, 1967). Monetary Policy also affects the level of aggregate demand. The tools that are used are either the rate of interest or the supply of money. In many countries, it is an acceptable view that the control of the money supply is probably the most significant tool to affect the level of demand in the economy (Stan & Grant, pp. 521, 1967). An increase in the level of interest will mean less spending, because people will tend to save more in such times, because the return on saving will be higher. However, when the interest rate is low, the cost of borrowing will be less, meaning that there will be an increase in borrowing and hence consumption. Therefore, the monetary policy is very important because it affects the level of aggregate demand. One very recent example of the importance of monetary policy is that during the Crash of 2008 in United States, for two years, the interest rate was maintained at 1% (New Work, 2008), which meant that the level of consumption was extremely high, and the cost of borrowing and housing prices were extremely low. This meant that there was an increased borrowing in the economy, and as the interest rates started to pick up in the year 2007, many borrowers started to default. Therefore, due to the mistake of Federal Reserve in not maneuvering the monetary policy properly, along with other people’s mistakes, resulted in the crash of 2008. However, the weak monetary policy was a major factor as well (Goliath Business News, N.p., N.d). However, behind these two policies there is a major debate. This is because there are different views within macroeconomics whether these policies should be pursued or not. There are certain advocates within economics who prefer government intervention and there are others, which do not. As mentioned above, there are two major views, Laissez-faire and interventionist. Laissez-faire advocate the free working of the market; letting the market run its course. This is where the factors of demand and supply are at force, and there is no intervention, except at the last resort. This approach goes back to 1776 when Adam Smith published his famous work “The Wealth of the Nations”. He spoke of an invisible hand, wherein when the individuals conduct their business according to the best-suited interests, the market will function extremely well (Abel & Bernnanke pp. 17, 2005). This type of approach is mostly used by classical or neo classical economists. According to classical economists, government intervention can sometimes have unintended consequences (Dixon, pp. 3, 2000). For example, the effects of fiscal policy might be effective after a certain time has passed; there might therefore be a time lag in government intervention. Government spending is usually tied down in long-term aspects for example the building of a bridge. Therefore, this may cause over heating in the economy (Stan & Grant, pp. 519, 1967). In addition, government intervention instead of having one effect might very well have some another effect. This approach however has strong policy connotations. It states that the government should have no hand in eliminating the business cycles (Abel & Bernnanke, pp.18, 2005). Interventionists, on the other hand, are usually that school of thought that is associated mostly with Keynesian. These economists view markets as inherently imperfect, and as such, require intervention. According to them, the market will tend to go wrong if it is left all on its own. In addition, the working of free market promotes inequality of income and wealth because of the concept of Pareto Optimality, and therefore, state has to intervene to get rid of this inequality in society. In addition, when there is domination in the market, the market will fail to function perfectly. Hence, market failure may occur (Dixon, pp. 3, 2000). This school of thought was developed after the Depression of 1930s, because the free market concept led the recession to continue to 10 years, when it in effect should have been a shorter span had the government intervened. Therefore, the concept of laissez faire failed during the Great Depression, because it took a very long time for the economy to recover. Therefore, the experience of the depression in the 1930s and the post war interventionists policies that were developed meant that this school of thought was highly popular from the 1930s till the 1970s (Dixon, pp.4, 2000). The debate whether to intervene or not to intervene is so popular because it has a lot of media interest. In addition, the fact that macroeconomic policy and performance are such common interest and concern for it affects the lives of the common man makes up for the reality that the debate is highly public (Abel & Bernnanke pp.16, 2005). However, given these two approaches, there is an underlying current. There is an evolution of the debate, because during the 1970s, there was both high unemployment and high inflation, which Keynes had denied in his approach. He had stated because of the wage rigidity, inflation and unemployment were inversely related. Therefore, because of this the faith in the Keynes approach, which was built after the Great Depression, was highly undermined (Abel & Bernnanke, pp. 19, 2005). Hence, the world was still confused on which approach to follow: the Keynesian or classical? Whether to intervene or not to intervene? The question of the paper seeks to examine whether government intervention is required or not. Given the recent occurrences, with the Credit Crunch of 2008, in which the government played a huge role in bailing out various banks and companies such as AIG insurance company in USA, and Europe doing the same in their case, one would suggest that a Keynesian approach was highly apt (Raynor, n.p, 2008). At the same time, however people question the viability of the monetary and fiscal policy for it brings with it many disadvantages such as time lag. In addition, the government expenditure that is employed in fiscal policy might crowd out private investment. Therefore, even if the government expenditure decreases, there might be an increase in investment, and therefore, an increase in the economic growth. However, because of the business cycles associated within an economy, the economy might be unstable. According to classical school of thought, it is because of these policies that trade cycles of booms and recessions are caused. On the other hand, Keynesians believe that business cycles can be caused also by private sector investment. Therefore, fiscal and monetary policy actually solve these cycles. The choice whether to choose monetary or fiscal policy at present has softened. This is because both groups have come to realize that there has to be a proper mix between the two to achieve macroeconomic goals. For example, monetary policy may be ineffective during Depression. Economic activity in such times can be rejuvenated only by fiscal action (Gupta, pp. 270, 2007). However, the debate whether to have government intervention is an ever-raging one, and as such has no answer. Both the Keynesian school of thought and the classical school have their own strengths and weaknesses. In addition, in the past twenty-five years, they have tried to correct their weaknesses. In current times, certain strengths are picked out from both schools of thoughts and there is excellent cross-fertilization occurring between them (Abel & Bernnanke pp. 19, 2005). Therefore, it can be ascertained that the current dilemma of macroeconomic policy is not the choice whether to choose monetary or fiscal policy but whether to intervene at all. References Abel, Andrew B, and Bernnanke, Ben S. 2005 "Introduction to Macroeconomics." Macroeconomics. New Delhi: Taj Press. 16-21. Print. New Work. 2008. Intervention. Retrieved on 28 March 2011: http://www.newwork.com/Pages/Opinion/Raynor/Intervention.html Dixon, Huw David. 2000 "Introduction.” Controversies in macroeconomics: growth, trade, and policy. Oxford: Blackwell Publishers Limited. 2-4. Print. Goliath Business News. 2009. "The crash of 2008: causes and lessons to be learned.” Goliath: Business Knowledge on Demand. N.p. Retrieved on 28 March 2011 Gupta, J. R. 2007. "Present State of Debate." Public Economics in IndiaTheory and Practice. New Delhi: Atlantic Publishers and Distributors. 270. Print. Langdana, Farrokh K. 2009. "Some Fundamental Definitions." Macroeconomic policy: demystifying monetary and fiscal policy. New York: Springer. 10. Print. Stan Lake, G. F, and Grant, S. J. 1967. "Government Policy." Introductory Economics. Sixth Edition ed. Singapore: Longman Singapore Publishers. 409-521. Print. UniversiTip. N.d. “The Aggregate Demand Equation.” Retrieved on March 28, 2011: Read More