Countering the Business Cycle - Essay Example

?Answer To counter the business cycle in an economy for public satisfaction, a federal government has many tools on its disposal that come into thecategories of Fiscal and Monetary tools. Which tools are better to use is more than just what theory can explain; it depends on the complexities the economy is facing at that time. Monetary policy is the main policy that deals with the supply of money in an economy; controlling this is one of the most essential tasks for the government. One of the very basic tools to control money supply is called the “Reserve Ratio” tool (also known as liquidity ratio). It is the ratio that banks keep with themselves against the deposits they receive; the bank cannot just lend out all the money it receives. A lesser reserve ratio by the government would mean that the commercial banks have to keep lesser sums of money with themselves and are free to lend out more money into the economy which becomes extended through the effect of “money multiplier”. If the government’s aim is to reduce inflation it can pump less money into the economy by increasing reserve ratio for which the banks would have to abide by and keep more money with themselves. All the commercial banks lend money from the Central bank (controlled by the government or the government’s bank – at times also referred as the bank’s bank). They have to pay money for this lend money to the central bank, in what our terms we call interest, the banks when borrow from the central bank is called the discount rate. A higher discount rate would lead the banks to borrow less from the central bank and thereby lending less to the public, which would in turn reduce the money supply in the economy. Conversely, if the federal government decides to increase the money supply, a decreased discount rate would be the option. In recent years following the recession, UK and other states have used different new tools like “Funding” and “Quantitative Easing” to control money supply as well. However, one of the most famous and influential tools of this monetary policy is “Open Market Operations”. As the term suggests, it’s more like what happens in a simple market, there are presence of buyers and sellers, but in this case, the product is not a grocery item but “MONEY”. The commercial banks are under the control of the central bank thereby they have to abide by the rules and regulations set by the Central bank. In this tool, there is a market of “bonds” and “money” whereby if the central bank wishes to contract the money supply, all it has to do is to print a fancy looking bond and write off an amount in it. Then it sells this bond on the written value to the commercial banks who have to buy the bonds; this reduces their money supply, in making up for their reserve ratio they have to make sure they lend out less as money has flown out of the commercial banking system onto to central bank; this has decreased the money supply in the economy. In contrast, if the federal government wishes to expand the money supply, it would purchase securities (bonds) from the central bank; the buyer gets the money and seller gets a piece of paper (Bond). In this market operation, the commercial bank has excess money to lend out because it has sold a bond, therefore after lending, through a multiplier effect the economy would enhance. This is one of the most commonplace tools used by the governments as it gives an efficient way of allocating money and it convenient without as such delays. The effect can also be forecasted depending on the values of the multiplier. It’s all a study about the state of the economy that will determine the success of any of these tools, but as statistics tell us, this has so far been the most effective tool used by governments today. Answer 2: In case of an easy money policy, the government simply decides to reduce the interest rates: As the interest rate falls from 10% to 8%, there becomes an excess demand for money as we move down the same supply “S1” curve for money. This excess demand for money is worth 25 billion as shown in the diagram (150 – 125). This is created because as the interest rate goes down, the public is less likely to keep their money in national savings or defense savings; they would now want to withdraw money because they are getting a lesser return on it, this phenomenon is driving the demand for money in the economy. This effect is likely to decreasing the savings in an economy; it might be a good sign if the objective is to expand and grow, although inflation would then be inevitable. A reduction in saving signifies decreasing MPS thereby increasing the effect of the Multiplier in an economy as it is given by the formula: Multiplier = 1 / Marginal propensity to save Similarly a tight money policy would mean the government decides to increase the interest rates. Let’s take the same above diagram as an example; if the interest rate goes up from 8% to 10%, people would be demanding less money; there would be excess supply of money in that case. This is because when the interest rate is high, people tend to save more by purchase of securities thereby giving up liquidity for interest rate increases. Up till now the discussion was limited to the effect on money supply, but it also caters to many other aspects of the economy. Increases or decreases in interest rates are directly linked to investments in an economy. The marginal efficiency of Capital (investment demand) theory explains as the interest rate goes up, people become less likely to invest as they are getting more from the interest rates rather than investments. It goes up to saying that people will only invest as long as the interest rate is below marginal efficiency of capital or investment demand as shown: Let’s say the interest rate is 6%, with such a low interest rate, investors would be more motivated to invest as they are hardly getting any returns on their capital while it sits back; therefore as the shaded region shows, the investors would invest 25 billion as the incentive to invest is large. The opposite situation would occur if the interest rate goes up to 10%; investors would be less willing to invest as many of the projects may not be giving returns that are over 10% as the MEC or Investment demand curve shows; therefore the investors would like their money to sit back and only the shaded region (as shown in the below diagram) would be invested which is very low as compared to a lower interest rate: Easy and tight money also have a direct impact on overall growth patterns of the economy; this is because they not only influence investments as shown in above diagrams but also consumption. With interest rates effecting two main components of the GDP, growth relies on interest rate largely. An easy money policy would lead to growth as interest rates are reduced; we saw an increase in the levels of investments. Furthermore, lower interest rate means lower payments for borrowers; they would have more to spend on consumption thereby increasing consumption. This would lead to growth in an economy and would move the “Aggregate Demand” (AD) curve to the right (AD1). However, this is not the only effect, through the expenditure multiplier effect, the AD curve would shift further to the right (AD2) moving the economy to the full employment level if the measure are taken effectively by the government. This phenomenon is shown in the diagram below: An easy money policy would cause inflation unlike a tight money policy; however, it is essential for growth of an economy to reach to the full employment (Natural rate of unemployment) level of output that in the above case is O3. Answer 3: The government has to intervene using these tools of monetary and fiscal policies when required. These steps are essential to make sure the business comes out of the economic recession or boom; booms are good but excessive inflation might be a by-product of such events. The rule of monetary policy is very strong; the whole economy revolves around this simple mechanism of money which is in the hands of the government. By having such a powerful instrument, the well being of the society greatly rests on the shoulders of the economic policy makers. But if this is as simple as the theory suggests, why aren’t all the economies booming and have good growth and GDP rates? The problem is the complexities involved in the real world scenario; political self interest, corruption, short term objectives are to name some of the leakages and complications that we face today. However, even after all the complications; the rule of using monetary policy still seems adequate as at largely, the economy relies on this source. There have been numerous instances whereby economies have escaped out of recession as a result of powerful monetary policies being used effectively. If we look at the world today, the complications require governments to do more; E.g. after 9/11, there was fear amongst the Americans of a recession, however through the help of media the government portrayed a positive message and used such side by side measure effectively alongside its monetary and fiscal policies that saved the U.S from recession at that time which would have been eminent without effective economics measures. Depending on situations, decisions have to be made. The world today has recently pulled out of a severe recession (the credit crunch 2008/2009), this has been done through different measures in different economies; in the U.S the bailout package boomed and saved the economy. The flow of money into the economic system at such times is essential otherwise people might lose faith and the economy might collapse. Even today, we have just recovered from the recent economic downturn; it is essential for governments to motivate people to spend more by giving out and adopting expansionary monetary policy. The growth in 2011 is forecasted to be the same as 2010; however that has changed for a country like Japan which has recently been struck by Mother Nature disrupting the overall balance of the economic equation. Answer 4: The two tools (monetary and fiscal) are not independent in the real world situations; we see the presence of banks in all economies followed by government taxes and government expenditure programs. This tells us that both the policies go hand in hand. It is important to understand that the two policies can complement each other in various situations. If we take the situation mentioned in the question whereby the economic recession is stimulated through a fiscal package where the government is increasing expenditures on public and reducing tax rates as to stimulate growth, we can conclude that the government is very likely to face a budget deficit (because government spending is exceeding the tax revenues). If this deficit is to be balanced out in the economy, the government would borrow from the non bank private sector in the economy i.e. the general public. When this happens, the government has to increase interest rates as to attract investments by the public; as the marginal efficiency of capital (or investment demand) theory suggests, the investors would be less likely to invest if the interest rate goes up – as illustrated in answer 2. This competition for funds with the private sector is crowding out the private investments and it may also under extreme situations lead to less growth instead of more growth. To counter this effect, it may be wise to use the monetary policy side by side, what usually happens in the world; both policies are used to complement each other. The monetary policy tools to be used at such a time may be the use of both open market operations along side with decreasing reserve ratio or discount rates. This would not only draw money out to finance the deficit in the economy (through open market operations) but also raise the money in the economy through the use of the other two effective tools that will keep the economy running smoothly by the use of both fiscal and monetary stimulus packages simultaneously. References: 1 – Wikipedia 2 – Global economic prospects for 2011 – By Micheal Mussa – April 2010 Read More