Invisible Hand Principle - Essay Example

?Running Head: INVISIBLE HAND Question Invisible Hand Adam Smith, a Scottish moral philosopher, is believed to be the father of the classical school of social sciences. His work involved the comparison of the “invisible hand” which leads to individuals seeking self-interests with the maximizing of overall public good. To this, in year 1776, Smith put it that it is neither from the butcher’s benevolence, nor that of the baker nor even of the brewer that people expect their supper but from the simple consideration of own interests and furthering them. Self interest is, thus, the major driving force in the increment of welfare of the people of a given nation. Therefore, the invisible hand is that process where while an individual is pursuing self interest, he/she promotes the overall societal welfare but not intentionally. On the contrary, Smith says that he had never in his lifetime known the goodness of the persons who involved in trade to achieve the main goal of the public welfare. In his book “The Wealth Of Nations” Smith has only one stand, that the invisible hand is the prime determinant of the public welfare. (Suntum, 2005 pp1-5) Command and Mixed Economies A command economy, which is also referred to as a planned economy, is one which has the state regulating resources. The state is the decision maker to come up with the allocation or utilization decisions of the available resources. It uses the services of certified planners who are just below the state in power to implement these decisions. (economicwatch.com, 2011) A command type of economy is not without merits and demerits alike. The merits of a command economy may include the main fact that they ensure that collective interests for the public good are maximized. Also governments which do their operations under this type of economy are able to mobilize as well as respond swiftly to raise capital and commence the process of production if need arises. (businessspan.com, 2011) The demerits associated with a command economy are the likes of the denial of sovereignty for individuals as regards the expression, working, earning and making expenditure choices. It as well assumes that people should be fully committed to work and they should aim at overall national welfare. There is the demerit of slowness in ensuring economic growth unlike the capitalist type of economy. Equality does not thrive in a communist economy since there is stratification. Lastly, there is lack of flexibility when it comes to moving from one decision to another for the welfare of the public. On the other hand, a mixed market involves a blending of the two major types of economy. That is, a command and a market type of economy. This is mostly the kind of approach by Italy, India, France and Sweden. Here, there is the government controlling of resources and the private sector. There are sectors in which distribution as well as production is under the state’s management. Sectors which have both the state and the private sector jointly involving in production and distribution and the sectors under which private control is in entirety. (Aswathappa, 2008 pp269,270) A mixed economy may be characterized by several advantages. Some of the advantages of a mixed economy are with the inclusion of the good regulation of prices in the market. Here, the state always ensures that prices do not soar above actual prices. It as well provides a level playground since there are private sectors involved in the market without compromising on the quality of commodities in the market. Natural resources are also optimally utilized due to there being the government and the private sector being involved in the allocation. People in a mixed economy have ample power when prices and quality of commodities is put into consideration. Monopoly cannot also thrive in a mixed economy as both the private enterprises and the government gets their hands in every business. (benefitsandadvantages.com, 2010) Critics state that a mixed economy is not the best type of economic approach of a nation. It has been put on the spot since it is stated to be confusing when it comes to decision making. Uniquely, this stands out as the only disadvantage of a fixed economy since it is a blending of the two major types of economies. Under the price mechanism economy type, individuals are not involved in the planning of the production of commodities, but this is determined by demand and supply interactions. The price factors are the determinant of whether to increase or reduce production. Where demand is higher than supply, price rises and suppliers produce more and the contrary is true. (Aswathappa, 2008 p268) Market Failures of Price Mechanism Price mechanism is often rocked with market failures where the market makes poor approaches to dealing with the externalities’ effects through their economic activities. This forms a major imperfection of price mechanism. Externalities can either be positive or detrimental. For negative externalities, the marginal cost of production of a given commodity, can be divided into two; the marginal private cost and the incidental costs. Marginal private costs are outlays incurred by persons carrying out the activity while incidental costs are the outlay-share paid by other people. For example, increased production in a factory means more operational costs as well as smoke, which is pollution to the external environment. Incidental costs are also known as marginal social costs. Negative externalities are usually a problem of the private firms since their main goal is to maximize shareholders’ value at the expense of others in the society. But laws to curb this have been put in place such that firms ensure corporate social responsibility is upheld. Where a firm is causing negative externalities, the output’s marginal benefits are usually lower than the marginal social costs under price mechanism. Therefore, lower output levels are the only solution to this. A graphical presentation of negative externalities is as follows: Figure 1: negative externalities Marginal Marginal social costs cost and revenue Marginal private cost A B Marginal revenue 0 output of factory per annum Under this type of negative externality, different equilibriums are reached while considering the costs of a society plus those incurred privately in production. It is assumed that B is the profit maximizing output for the factory. At this point one can see that the marginal social cost is way above Marginal Private cost. (Baumol and Blinder, 2008 pp312-314) Conclusion According to Adam Smith’s words, he says that the allocation of resources should always be left to the mechanism or the invisible hand. Precisely, as he put it, this type of economic approach will ensure minimal resource misappropriation if any occurs. To explain this, he says that under command economies there is a lot of waste and corruption. Smith puts it that it is a matter of other people spending money belonging to others and thus it cannot be expected for them to take vigilance while expending. He himself was in an economy that was socialist and he went on to put it that heavily planned types of economies were characterized by people above the legal system and who instead of watching over private persons’ money would simply spend wildly using the same at the expense of the private society. Thus, price mechanism is the best type of the economic approach according to the sentiments by Adam Smith. (Joyce, 2001) Question 2 Monetary and Fiscal policies disambiguation A monetary policy is fundamentally implemented or put into work by a nation’s Central Bank while the national government takes the biggest responsibility when it comes to fiscal policies. Generally, while a stimulative fiscal policy involves moves like tax cuts and increases of expenditure by the government which in turn stimulates the growth of the economy over the short-term. A stimulative approach of monetary policy is likewise set to improve the rate of economic growth in terms of GDP in the short-run. The vice versa in both cases would have an opposite effect to the economy. The major tool applied by the Central Bank in the monetary policy approach is the utilization of the interest rates of lending for banks. On the other hand, a fiscal policy is majorly an issue of the national government’s changing the types of taxes and their rates as well as buying commodities and expending on transfer payments. These two major types of macroeconomic policies are set to ensure stability in the overall economy. (frbsf.org, 2002) Differentiating a Credit Crunch and Credit Borrowing A credit crunch is a situation arising where in the money market loans become hard to obtain especially when the government seeks to put inflation under control by putting restrictions upon lending to small businesses and consumers alike. Credit borrowing on the other hand is the receipt of a valuable thing in exchange for a payback obligation mostly in bigger value at a certain point in time in future. (businessdictionary.com, 2011) Lower than usual interest rates In the period from 2004 to 2006, rates of interest in the USA increased from1-5.35% which in turn caused the housing market in the USA to hit a slump. The clients who had bought houses at lower rates of interest had no choice but to start defaulting loans of mortgage. Due to the gigantic rise in the default rates, the financial system had to feel the ultimate impact since the numerous numbers of mortgages were sold on to the investors and banks. This caused the birth of the credit crunch. Lehman Brothers made a pioneering of the major banks that caved in during the credit crunch. (bbc.co.uk, 2009) Most Affected Economies by the Credit Crunch The analysis presented by the bbc website had a list of countries affected by the credit crunch. Among them was the USA, at first the federal reserve had no choice but to lower their key rate of interest from 1.5-1%. Japan was also another hard hit economy and towards end 2008 the bank of Japan cut the interest rates by o.2% from 0.5-0.3%. UK was another victim of the financial crisis and it had its government plan to inject ?37 billion in 2008 October into its economy to curb the effects. Monetary Policy Monetary policy is an expression which describes the action by the Central Bank describable through interest rates or money supply terms. When the Central Bank sets a given rate of interest, it goes further to commit itself in the adjustment of supply of money so that the equilibrium of the money market is achieved. The mostly used tool by the Central Banks is bonds, where; to make a raise in the levels of money supply in the economy, the Central Bank buys bonds from the hands of the public and if it wants a reduction in money supply it sells of the bonds to the public. These are usually at a given rate of interest so as to stabilize the economy. A change in the monetary policy meant to increase the aggregate demand amounts can either be described in terms of raising money supply or as the rate of interest’s lowering. The policy for contracting levels of aggregate demand on the contrary can be said to be a decreasing of money supply or increasing the rates of interest. (Mankiw, 2008 p481) On the topic of money supply, Friedman said that the money supply function as not related to the money demand one. Money supply function is dependent upon psychological factors and political factors unlike the demand for money. Just as Keynes asserts, Friedman makes an assumption that money supply is set by the central bank. Therefore, in the macroeconomic analysis, supply of money function is an exogenous variable. However, a Handa writes, the idea of Friedman that money supply is exogenous, it was not the case in the mid 1990s when interest rates were the primary instrument of monetary policy and money supply was just endogenously determined. The Keynesian model, after Friedman’s, which was after mid 1990s assumed that the interest rates were set by the Central Bank and so the money supply function became endogenous in the monetary policy function. (Handa, 2008 p65) Cash Injections in the US and UK Markets Cash injections by the UK government in year 2007 were pounds 37 billion. This cash was directly meant for three banks Lloyds, Royal bank and HBOS. The government would in return to these injections have a say on the running of the banks. (In USD, 37 billion pounds would be 61.7 billion USD). (bbc.co.uk, 2008) In year 2008, the USA’s bailout plan signed by the then President Bush involved USD 700 billion. (Clark, 2008) USA’s benchmark rates of interest were reported as 0.25% in March 2011. On expounding further and digging into the history, the rates of interest in the USA from 2006 to 2011 were, 4.25%, 5.25%, 4.3%, 0.25%, 0.25%, and 0.25% in the equivalent years. In the UK, they were as follows; 2006-2011, 4.6%, 5.0%, 5.5%, 1.0%, 0.5%, and 0.5% in the corresponding years. Note that the rates are based on January each year. Fiscal Policy of the UK from 2007-2011 When Gordon Brown was chancellor in the UK, the Labour party, took up the ‘Golden Rule’ officially in the in the streamlining of the fiscal policy formulation. This golden rule says that in the full cycle of the economy, the state should borrow so as to invest solely for the future needs. Currently prevailing needs would be met by the tax collections. This would allow stability in terms of finances as the ratios of the public sector define the debt, net worth and the current spending. Together with the golden rule, the government of UK sought to adhere to the rule of sustainable investment which would ensure that the national debt would remain at the manageable level of 40% of the economy’s GDP. In year 2008 it hit 42% and in year 2010 it was 70%. This meant that the rule had been flouted. However, justification had been put across as to have been due to ensuring economic stimulus as the global crisis hit the economy to allow recovery. (economicwatch.com, 2011) The main proposals by the UK budget in March 2011 which was dubbed ‘green budget’ had the government put its focus on the policy challenges which were facing the exchequer’s chancellor just before 2011. The plans were to cut public expenditure and come up with decisions on tax cuts like corporate tax rates. (ifs.org.uk, 2011) Potential Problems of Debt The national debt of UK was formed by the aggregate amount of monies that were owed by the government of Britain to the buyers of UK gifts and the private sector. The net debt of the public sector of UK was approximated at pounds 875.8 billion and this formed 58% of the GDP of UK. The debt was in exclusion of the intervention of the financial sector. Where the intervention of the financial sector was put into consideration the net amount of debt amounted to pounds 2,252.1 billion or around 149.1%. This inclusion is referred to as the adjustment of the measure of the public sector amount of the net debt. The forecast for the total public borrowing for the year 2010/2011 was 149 pounds and this would be 12.6% of the UK’s GDP then. Subsequent to the period of the financial crisis the percentage of national debt reduced to about 25% of the year 2002’s GDP. In year 2002 through 2007, the percentage grew from 30% to 37%. This was in spite of the big financial expansion of a long time. The reason to this was the state’s decision to raise the expenditure upon the education and health. In year 2008, the national debt rose by a big margin due to economic recession, low tax revenue receipts and the financial bail outs of the banks. The cost attached to UK’s national budget is the government’s interest that it has to pay upon the gilts sold and bonds. Debt interest in year 2010 amounted to pounds 21.6 billion and this would suggest an annual cost of about pounds 43 billion which translated to 3% of the GDP. In future the predictions of the National debt are that it would escalate up to around 100% of GDP of year 2012 and onwards. This goes above the set 40% of the state’s sustainable investment. This predicament can be solved through the expansion of the economy which raises tax revenues, better performance of banks and cutting of government expenditure together with the raising of amount of taxes. The major problem of the national debt may be with the inclusion of interest cost of the state’s debt that has grown too high in amounts, high rates of taxes foreseen in the economy’s future, private sector’s crowding out, structural deficit may get worse due to the trends of the aging population, a negative effect on the rate of exchange may occur and the escalation of the interest rates where the markets are reluctant to accept the borrowings made by the UK. (economicshelp.org, 2011) As per the presentation of the national statistics of the UK, the gross external debt stood at pounds 6,290 billion which forms about 430% of the GDP of 2009. The biggest percentage of the amount was attributable to the banking sector at pounds 4,000 billion. The banking obligations are suggested to be offset with the foreign asset’s disposal. The main problem is that they might have lost value, though. (economicshelp.org, 2009) Risks Associated With Expenditure Cuts According to the article by the BBC news in 2010 state expenditure’s cut would push the UK’s unemployment levels upwards from the then 2.5 million to around 3 million. The decrease of deficit would cause a stalled recovery in the labour market as well. However, the government’s plan is to ensure that the process of the state-expenditure cut would not negatively affect the job market. It would safeguard on the growth in the future. This would be achieved through a radical re-engineering that would set off with expenditure cuts such that a cut by pounds 4 would be followed by a pound 1 raise in the amount of taxes. (bbc.co.uk, 2010) Conclusion While concluding, it is vital to consider how a government handles issues that affect its nationals. Opinion polls may be carried out to reflect on how well a government has handled issues of the economy using the monetary and fiscal policies. For example; opinion polls in may be carried out on the economy’s performance like the one carried out on Thatcher’s government in the 1990s. Even though the electorates may ignore opinion polls, the performance of the government has to be gauged anyway. For in stance, a check on the levels of inflation, balance of payments, unemployment levels, the growth of the economy in general and the rates of interest. The prospects of the future of the government and the plans it has for the benefit of the nationals may also be a measure of how people trust the government or how they view the governance of the day. The government’s reputation is, thus, dependent upon the reputation it has from its people as regards the macroeconomic factors. (Jones, et al p112) Reference: Aswathappa. (2008). International Business. Edition 3. Tata McGraw-Hill Education. p268. Baumol, William J. and  Blinder, Alan S. (2008). Economics: Principles and Policy. Edition 11. Cengage Learning. pp312-314. bbc.co.uk . (2009). Timeline: Credit crunch to downturn. Retrieved 17 April 2011http://news.bbc.co.uk/2/hi/7521250.stm bbc.co.uk. (2010). UK cuts 'to push unemployment close to 3m. Retrieved 17 April 2011 http://www. /news/10280461 benefitsandadvantages.com. (2010). Advantages of mixed economy. Retrieved 17 April http://benefitsandadvantages.com/general/advantages-of-mixed-economy.html businessdictionary.com. (2011). 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