The Economy of the United States - Essay Example

?Question At present, the economy of the United s is below its full level of employment (i.e. Natural rate of unemployment); to boost it up weneed effective measure using the tools held by government to get the economy to the full employment level as to minimize the deflationary gap. Since I am told by Mrs. President to only use the fiscal policy tool of Government expenditure, I would increase government spending but by a small amount as small increases in government spending have relatively greater effects on the economy due to the presence of the Expenditure Multiplier. The expenditure multiplier is a constant that gives the value (a ratio) to what you will put in the economy and what you will get out of it as a result. It is an increased (multiplied) value because once money comes into the economy; it changes many hands and gradually multiplies. We first need to know the value of the multiplier before determining the amount by which we ought to increase government spending. Multiplier = 1 / MPS We know what the MPC is because MPC + MPS = 1 We can find out the value of MPS that is: 0.8 + MPS = 1 MPS = 1 – 0-.8 MPS = 0.2 Since MPS = 0.2, Multiplier = 1 / MPS Multiplier = 1 / 0.2 Multiplier = 5 At present, the economy lacks behind full employment by $2000 as the full employment level is $10,000 and we are currently at $8,000 (10,000 – 80000), to fulfill this gap, we will not increase government spending by 2000 as that would increase the total output to a large extent owing to the presence of the Expenditure multiplier, therefore we would increase it by: 2000 / Multiplier 2000 / 5 = $400 A $400 increase in Government spending would automatically trigger an increase of $2000 in the economy owing to the presence of the multiplier (i.e. 400 * 5 = $2000) Question 2: The other aspect of Fiscal tool that the government has on its disposal is the “taxes” which it can alter depending on the state of the economy. Since the President has asked me to work on the fiscal measure owing to popular public demand, we can work with it as well. First of all, it is important to understand that taxes are not a direct component of the GDP unlike government expenditure; they influence consumption. Also, tax cuts are feared to be saved to an extent depending on the public’s expectations (example, if there is more employment in the economy, GDP is likely to rise greatly, however, decreases in tax rates might even be saved by the households), therefore, the value of the tax multiplier is less than that of the expenditure multiplier; which means I would have to reduce taxes to a greater extent as compared to government expenditure to get the $2000 increase in GDP. Tax Multiplier: MPC / MPC Since MPC = 0.8 and MPS = 0.2 Tax Multiplier = 0.8 / 0.2 Tax Multiplier = 4 (Which is one less than the expenditure multiplier that was “5”) For the economy to boost to full employment, tax cuts would have to be given in accordance with the multiplier: 2000 / Tax Multiplier 2000/4 = $500 Therefore, it is evident, for the economy to go to the full employment level of $10,000, tax cuts worth 500 have to be given (which are 100 more than the expenditure if the government were to use that). This makes the government spending policy more attractive as compared to giving tax incentives to people. Question 3: If the president were to match increases in federal government expenditures with the offsetting increases in taxation, it would never give out a balanced budget. It is important to note that because of a leakage i.e. saving, a tax cut never gives out its full multiplier effect; tax cuts affect consumption and are not a direct part of the GDP. On the other hand, government expenditure is direct component of GDP as shown: Taking closer looks at the formula of tax multiplier (i.e. MPC/MPS) and comparing it to the expenditure multiplier, one would realize that the tax multiplier would always be “1” less than the government expenditure multiplier; therefore equal increases or decreases in both would not give out a balanced budget, the tax cut would have to be of greater value to balance the budget. As we saw in the above example, to get to equilibrium, government spending had to be increased by just $400 whereas tax cuts worth $500 were needed to achieve the same level of GDP. Question 4: In many developing countries, accumulating public debts is a problem. In such Countries, the government spending is more than the tax revenues collected yet the GDP growth is slow and steady. Taking Pakistan’s example, one is aware of the high level corruption on political level which tends to be a leakage from the circular flow of income. In such a situation, a counter cyclical fiscal policy may prove to be ineffective as the debt has already grown and further increases in such a debt may cause a country to suffer, which in Pakistan’s case has happened as it has borrowed large sums of money from the IMF (International Monetary Fund). In case of recession, if a Country were to use its fiscal tools to counter this cycle, it would reduce taxes and increase government spending; however countries like Pakistan are forced to do the opposite in order to attain more revenue at the cost of economic development as a result of obligations from IMF. If another example is of a Country which is rapidly growing, it would be experiencing inflation and may be under public pressure to reduce taxes if nothing else. In such situations, the fiscal tools the government has may become completely ineffective. Question 5: A federal budget should not be balanced annually; it all boils down to the fact what the economy ought to do in the future. It may run deficits or surpluses, and both of these may be successful or harmful for the economy at the same time. E.g. U.S ran a deficit for consecutive years from 1969 till 1998, it may be a large time and one may make an abrupt conclusion that it’s bad for the economy, however the fact is that the deficit actually helped the economy grow and enhance its GDP in the long run as supported by the economists known as “deficit doves”. The estimated National debt amounted to $5.5 trillion, yet in the years to come it managed to gain surpluses as a result of a healthy economy; in 2001 the estimated surplus was around $184 billion. Therefore, the point is, an economy has to look at the productive side of everything, it’s very important for economists to understand the gravity of the situation an economy is in at present and then come to conclusions; deficits may be healthy and later on turn to economic growth and higher GDP. If the government were to balance the budget annually, it may restrict itself to the level of output it currently stands at, or even if it were to increase it, calculating equal amounts of tax increases to balance the overall equation of revenue and expenses isn’t simple mathematics; an economy is a very complex structure with a lot of leakages (Greece had been estimated to have an underground economy of $35 billion). Therefore, it is wise to let the economy go in the flow that would benefit it the most, be it running a deficit or a surplus, and not restrict it to having a balanced budget. However, some key elements have to be taken into consideration; an economist has to make sure even if the equilibrium or balanced federal budget is not a target, too much drifting away may cause increases in National debt and a further problem for the economy. Although deficits may be good for a time, they need to be in limits and properly managed to effective outcome in the long run like that of the U.S. References: Dawn News – For Pakistan’s example Constitutional Rights Foundation – for U.S example Read More