The Economic Stimulus Plan - Essay Example

? The effect of a temporary positive aggregate demand shock is shown above in the diagram. Initially, the economy starts off at the long run equilibrium point E0. Observe that the Long Run Aggregate Supply (LRAS) curve is vertical at output level Y*. The Aggregate Demand (AD0) and the Short-Run aggregate supply (SRAS0) curve intersect at this level of output resulting in the equilibrium price level = P0. As a result of the positive demand shock at t=1, the AD curve shifts out to AD1. The SRAS curve remains the same. As a result the new short-run equilibrium point at t=1 is E1. Short run aggregate output increases to Y1 and the price level rises to P1. In period t=2, the AD curve shifts back to its initial pre-shock level AD0. This can be thought of as a result of the rise in price levels. However, because of the price rise, the SRAS curve shifts out to SRAS2. As a result the short-run equilibrium in period 2 is E2, Output falls to Y2 and the price level shoots down to P2. Hereon, the aggregate demand curve remains stationary, and the SRAS gradually climbs along the AD curve back to the initial equilibrium level. The price climbs up back to P0 and the output level converges to its long run level over the long run. Thus, in the long run there are no effects of the positive demand shock since it is temporary. However, there are short-and medium run effects. 2. To answer this question it is important to understand what the role of MPC is in the construction of the IS curve. In the diagram above, we show how an increase in investment affects the goods market equilibrium. Suppose initially the interest rate was fixed at r0 and the investment expenditure was I0. The Effective demand was E0 = C+I0+G. As shown in the above part of the diagram, the effective demand intersects the 45 degree line at output level Y*. Thus, the combination (r0,Y*) ensures equilibrium in the goods market. It is thus a point on the IS curve. Now suppose the interest rate falls to r1. As a result investment rises to I1. So, there is an increase in effective demand as well. Consequentially, Y** is the new equilibrium point. Therefore (r1,Y**) is another equilibrium combination of interest and real income. Joining these we get the IS curve in the lower half of diagram 2. The crucial point to note here is that the slope of the IS curve depends crucially on the slope of the effective demand curve, which is the MPC. Evidently if the Effective demand curve was steeper implying a higher MPC, then the increase in equilibrium income would have been smaller. Thus, we understand that higher the MPC, steeper will be the IS curve. The increase in equilibrium income following an autonomous increase in investment follows a multiplier mechanism. The value of the multiplier is equal to: . Therefore if the mpc = .75, multiplier is equal to 4 and if mpc = 0.25, the multiplier is equal to 1.33. Therefore, the increase in the income will be equal to 4*60 =$ 240 million in the first case while it will be only $79.8 million in the latter case. The reason for a smaller increase in income when the mpc is smaller lies in the definition of the mpc. It stands for the additional spending on consumption from each additional dollar earned. The higher this value, the higher will be the increase in effective demand following every increase in income. The propagation will be greater, greater the mpc. 3. Obama selling hard on economic stimulus plan AGENCIES, Jan 25, 2009, 07.49pm IST WASHINGTON: President Barack Obama relentlessly pressed his sales pitch for $825 billion in government spending to halt the US economic slide, dispatching his vice president and top economic adviser for appearances on Sunday television interview programs. Vice President Joe Biden and Larry Summers, the economic chieftain, will be emphasising the message outlined by Obama in his first Saturday radio and Internet address from the White House. The new president touted the benefits of the huge spending program, telling Americans it would produce better schools, lower electricity bills and provide health care insurance coverage for the millions now unemployed or likely to lose their jobs in the worst economic collapse since the 1930s. Obama was trying to build public support and put pressure on some recalcitrant lawmakers for the for the $825 billion plan even as White House aides refused to rule out a second economic package. "Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. And we could lose a generation of potential, as more young Americans are forced to forgo college dreams or the chance to train for the jobs of the future," Obama said on Saturday in a five-minute address. "In short, if we do not act boldly and swiftly, a bad situation could become dramatically worse." As he tried to sell Americans on the massive plan, some in the administration said there was consideration being given to a second economic recovery plan to salvage the economy. The idea was to assuage members of their own Democratic Party who fret that too little of the money is going toward public works projects that would employ their constituents. Along with the speech, Obama's economic team released a report designed to outline tangible benefits of the plan and shore up support. Aides said they wanted people to understand exactly what they could expect if Congress supported the proposed legislation. The United States lost 2.6 million jobs last year, the most in any single year since World War II. Manufacturing is at a 28-year low and even Obama's economists say unemployment could top 10 per cent before the recession ends. One in 10 homeowners is at risk of foreclosure and the dollar continues its slide in value. On Friday, 1st Centennial Bank of Redlands, California, became the third US bank to fail this year. The president and his top economic advisers met at the White House on Saturday to discuss economic issues. In addition to the stimulus package, the assembled experts used the two-hour session to discuss the upcoming federal budget, Obama's first chance to shape the country's spending. A day earlier, Obama invited Democratic and Republican leaders to the White House to hear their ideas on the economy. "We presented President Obama with our ideas to jump start the economy through fast-acting tax relief—not slow-moving government spending programs," House Republican leader John Boehner of Ohio said in the weekly Republican address. "We let families, entrepreneurs, small businesses, and the self-employed keep more of what they earn to encourage investment and create millions of new private-sector jobs." Boehner, who was also appearing on the talk shows, said the Republicans would cut taxes for every taxpayer, dropping even the lowest income tax rates. "That's up to an extra $3,200 per family every year—money that can be saved, spent or invested in any way you see fit," Boehner said. He also proposed a tax credit for home purchases, an end of taxation of unemployment benefits and tax incentives for small businesses to invest in new equipment and hire new employees. "We cannot borrow and spend our way back to prosperity," Boehner said. Obama currently enjoys wide public support. The Gallup Organisation on Saturday said 68 per cent of Americans approve of Obama's performance in his first days in office. That's a number near the high end for new presidents, but short of President John F. Kennedy's 72 per cent in 1961. Gallup's poll found that 12 per cent in the survey disapprove of Obama's job performance. That number is typical of all presidents. The telephone interviews of 1,591 adults were conducted from Wednesday to Friday. The margin of sampling error is plus or minus 3 percentage points. Obama plans to travel to Capitol Hill on Tuesday to meet with Republican leaders, his latest move to pass an economic package that has some Republican support. Many of the goals in the speech and report were familiar from Obama's two-year campaign, such as shifting to electronic medical records and investing in preventive health care. There is a heavy emphasis on public works projects, which have lagged as state budgets contracted. Obama's plan would also provide health care coverage for 8.5 million people who lose their insurance when they either lose or shift jobs. "It's a plan that will save or create 3 to 4 million jobs over the next few years" and recognises "there are millions of Americans trying to find work even as, all around the country, there's so much work to be done," he said. But Obama cautioned against expecting instant results: "No one policy or program will solve the challenges we face right now, nor will this crisis recede in a short period of time." - The Economic Times, Jan 25th 2009 The article above discusses about how President Obama plans to use a substantial fiscal spending package to extract the economy from its recession. The mechanism can be illustrated using a simple IS-LM framework. As shown in the diagram below, an increase in government spending expenditure will lead to a rise in the effective demand which will lead to an increase in equilibrium output and employment via the multiplier effect. Read More