Business Economics Issues - Essay Example

? i) Recession refers to represents a contraction in the business cycle resulting in decline in economy activity. It can be represented as a fall in GDP which comprises of Consumption, Investment, Government Expenditure and Net Exports (GDP(Y) = C+I+G+NX) (Michl, 2002). According to Julius Shikshin, it can be defined as the fall in GDP by two quarters. Some economists define it as a 1.5% rise in unemployment in a year (Michl, 2002). Double-dip recession is a state of the economy whereby the GDP slips back to negative levels after one or two quarters of positive growth. Thus, a double-dip recession occurs when the GDP rises to positive levels (the recovery period) followed by negative levels (another recession) (Quiggin, 2010). It is often referred to as the “W-shaped” recession (Quiggin, 2010). One of the most prominent double-dip recessions took place in the 1980’s in the United States (Appendix 1) (Quiggin, 2010). Two recessions occurred in the 1980’s in the United States. Initially, the economy shrunk by 8%, then grew at 8% after which the economy dipped into the second recession due to the Federal Reserve’s policy to raise interest rates to curb inflation (Quiggin, 2010). Following that, the economy re-entered into growth for the rest of the years (Quiggin, 2010). Although, there are no definite characteristics that define a recession, there are a few symptoms that are generally agreed by economists. First is the inverted yield curve model which was determined by Jonathan H. Wright which uses 10 year yield of Treasury Securities as an input (LaBonte et al., 2010). Second, is the change in unemployment rate over a three month period (LaBonte et al., 2010). Third, lower prices of assets including real estate and financial assets as well as large personal and corporate debts (LaBonte et al., 2010). ii) The contraction in Ireland’s economy was of particular significance at a time when other Euro nations were showing positive growth rates. This fall in Ireland’s GDP is attributed firstly, according to Author of the Bulletin, Dr. Dan McLaughlin, Group Chief Economist, Bank of Ireland, to the drastic fall in capital spending. Although capital spending decreased by 11%, on average, throughout the rest of the developed world; in Ireland it fell by a drastic 30% along with a 34% decline in building and construction activity (McLaughlin, 2010). The share of construction in general, and house-building in particular now accounts for only 2.5% of Ireland’s GDP, compared to 12% in 2005 (McLaughlin, 2010). Secondly, consumption expenditure also saw a decline throughout the Western regime by 1.1%, due to reduced employment and falling growth in wages (McLaughlin, 2010). In the case of Ireland, employment slashed by 8% along with decline in wages which partially contributes to the fall in real consumer purchase power of Ireland (McLaughlin, 2010). A significant trend emerged at this point; that of higher savings. Although real disposable income dipped in Ireland, it was accompanied by a rise in the marginal propensity to save, leading to a higher savings ratio (McLaughlin, 2010). At the same time, Ireland’s exports fell by much more than that of its Euro competitors, implying that Net Exports also declined. Thus, to sum up; since all the components of GDP including consumption, investment and government expenditure along with net exports fell, GDP was bound to decline. iii) A Keynesian style stimulus package is a policy measure used by policymakers and institutions that involves stimulating one or more of the components that make up aggregate demand in an attempt to increase employment, income and output of an economy (Tool & Samuels, 1989). This approach is consistent with the Keynesian theory that negative output gap can lead to a bottleneck in the economy; a situation it finds difficult to escape. The paradox of thrift comes into force whereby loss of valuable consumer and investor confidence combined with high propensity to save exacerbates the recession (Meltzer, 1988). If such is the situation, negative multiplier and accelerator forces can further worsen recession by pulling down aggregate demand leading to further loss of jobs. Policymakers use several tools to implement the Keynesian style stimulus package. The monetary policy and fiscal policy are both means to this end; that is, they both are active agents for altering aggregate demand (Macdonald, 1999). Firstly, under the fiscal policy, government expenditure is increased deliberately by injecting it into infrastructure development which is ideally backed by some sort of government borrowing (Tobin & Jackson, 1989). The multiplier effect is likely to play a role here; increase in government expenditure translates to higher aggregate demand which, in turn, raises income and output and positively affects employment. To this effect, the risk of running a budget deficit leading to crowing out of private sector investments is reduced manifold. Secondly, by reducing the taxes payable by lower-income groups is likely to increase consumption expenditure by a larger amount compared to other affluent segments as this group has a larger propensity to consume than any other group (Arnold, 2008). Third, under monetary policy, stimulus is provided by increasing the money supply and credit which ultimately lowers interest rates making savings less attractive ( thus increasing consumption) and making investments more lucrative ( thus, increasing investment component of aggregate demand) (Schug & Wood, 2011). Money supply can be increased through various ways by the government; however, the mechanism remains the same. One way of doing so is conducting open market operations and buying securities in the open market, thus increasing reserves with banks leading to higher loans and higher money supply (Schug & Wood, 2011). Fourth, the government can reduce the discount rate which is the rate at which banks borrow money from the discount window (Schug & Wood, 2011). As the discount rate declines, banks are encouraged to borrow from the Federal Reserve, which increases the loans made by banks and the resulting effect of money multiplier which increases the supply of money. The resulting impact on AD under both fiscal and monetary policies is shown in Appendix 2. The diagrams show that changes in fiscal policy results in outward/inward shift of the IS/IM curve resulting , ultimately, in an increase/ decrease in AD (Lipsey & Chrystal, 2007). Some sort of fiscal stimulus is always there in recessionary times due to the presence of automatic stabilizers in an economy. It is a “social-welfare security net” which is built into an economy and operates in the form of increased government borrowings in recessionary times (Lipsey & Chrystal, 2007). As more job losses are incurred, the government, by default, is pressurized to step in by providing welfare aid, while at the same time, bearing the brunt of lowered revenues from taxes. However, the effectiveness of these policies will depend on the effectiveness of fiscal measures vs. monetary measures in the context of local interest rate dynamics. Questions arise as how the increased government borrowing is likely to affect existing distribution of income and wealth along with the difficulty to measure the size of the multiplier and estimate the resulting impact on aggregate demand (Lipsey & Chrystal, 2007). Finally, a compromise of short term vs. long term objectives needs to be reached in order to maximize the effectiveness of this stimulus package. iv) To begin with, aggregate demand/ aggregate income/ aggregate expenditure can be seen as a composition of 4 core elements: Consumption (C), Investment (I), Government (G) and Net Exports (NX). Thus the Aggregate expenditure (AE) function is as follows: AE = C + I + G + NX Thus, clearly in order to increase Aggregate demand (AD) or aggregate expenditure as a whole, any one of more than one of the components of aggregate demand maybe targeted. To this end the monetary policy is one of the tools at the discretion of governments to stimulate AD/AE. Either an expansionary or a contractionary monetary policy maybe used depending on whether the government intends to increase or lower the AD respectively. Keeping in mind the AD/AS graph, monetary policy influences aggregate demand indirectly through its influence on interest rates. Furthermore, it is important to note that interest rates in an economy are subject to the Theory of Liquidity Preferences as developed by Keynes under which equilibrium interest rates are obtained through the intersection of Money Demand and Money Supply (Appendix 3) (Lipsey & Chrystal, 2007). Thus, interest rates are assumed to respond to changes in either money demand or money supply. An expansionary policy may be used to fill a deflationary gap as in the case of Ireland (Appendix 4). Under an expansionary monetary policy, the Central Bank (or Fed) increases the supply of money through any of the several ways it has at its disposal. Thus, the Fed can decrease money supply through changing reserve requirements (reserve ratio), conducting open market operations, arranging for REPO and reverse REPO and influencing the discount rate at which commercial banks borrow from the central bank. By increasing money supply, the interest rates in the economy generally go down which then affects each component of AD (Lipsey & Chrystal, 2007). As interest rates rise, the marginal propensity to save tends to go down, which in turn implies a rising marginal propensity to consume ( since mps= 1-mpc) (Lipsey & Chrystal, 2007). In the simplistic case, consumption expenditure thus rises. On the other hand, a fall in interest rates tends to makes the incentive to invest in investment projects stronger with the effect of increasing the Investment component of AD (Lipsey & Chrystal, 2007). Furthermore, investment in capital stock results in the setting in of the Accelerator effect which enables output and incomes to continue to rise in the long run, causing an outward shift of the LRAS curve (Lipsey & Chrystal, 2007). Thus not only in the short run, but also in the long run does AD/AE rise. As far as Net Exports are concerned, there are two major ways through which an expansionary monetary policy affects NX: firstly, by increasing local demand the balance of trade declines (income-absorption effect); secondly, the corresponding depreciation in currency exchange rate tends to make exports cheaper and imports expensive (expenditure-switching effect), with the net result that imports decrease and exports increase leading to rise in Net Exports (Lipsey & Chrystal, 2007). Thus, with an expansionary monetary policy, aggregate demand tends to rise (Appendix 5). The main problem with the use of this policy in the case of Ireland is that particular income groups or segments of the population cannot be targeted as the monetary policy works holistically and homogenously for all strata of the society unlike a fiscal policy. It is generally proven that under recessionary conditions, as is the case with Ireland, the effectiveness of using monetary policy to stimulate AD declines. Another major issue is that of long time lags as far as monetary policy is concerned; it takes approximately 6-12 months for investment to respond to changes in interest rates (Schug & Wood, 2011). Thus, by the time the mechanism starts impacting the economy, chances are that the economic situations have changed making the tools ineffective. Furthermore, it is likely that an expansionary monetary policy will not lead to an increase in Ireland’s AD/AE. For instance, the Fed increases supply of money through various instruments (reserve requirements, discount rates, open market operations, REPO/Reverse REPO) and lowers interest rates. This will directly cause consumption and investment to rise. However, if net exports fall by the same amount as both components rise, the effect is nullified and AD remains constant. In this case only the composition of output is affected not the output itself. Thus monetary policy can not solely be relied upon; it needs to be complemented with expansionary fiscal policy (reducing taxes and increasing government spending) in order to fill the prevailing recessionary gap in Ireland. References: Arnold, R.A., 2008. Economics. 9th ed. Mason: South-Western Cengage Learning. Hubbard, 2007. How the Expansionary Monetary Policy Works. Available at: [Accessed 12 May 2011]. Krugman, 2009. Effect of an Increase of Money Supply on the Interest Rate. Available at: [Accessed 13 May 2011]. LaBonte, M., Net, T. & Purcell, P., 2010. Recession, Depression, Insolvency, Bankruptcy, and Federal Bailouts. Vancouver: The Capitol.Net Inc. Lipsey, R.G. & Chrystal, K.A., 2007. Economics. 11th ed. Oxford: Oxford University Press. Lipsey, R.G. & Chrystal, K.A., 2007. Expansionary Monetary Policy to Fight a Recessionary Gap. Available at : [Accessed 13 May 2011]. Macdonald, N.T., 1999. Macroeconomics and business: an interactive approach. London: Thomson Learning. McLaughlin, D.D., 2010. Irish domestic spending fell more than the Euro norm Ireland according to Bank of Ireland - Exports proved the exception. [Online] Bank of Ireland Available at: HYPERLINK "http://www.bankofireland.com/about-boi-group/press-room/press-releases/item/26/irish-domestic-spending-fell-more-than-the-euro-norm-ireland-according-to-bank-of-ireland-exports-proved-the-exception/" http://www.bankofireland.com/about-boi-group/press-room/press-releases/item/26/irish-domestic-spending-fell-more-than-the-euro-norm-ireland-according-to-bank-of-ireland-exports-proved-the-exception/ [Accessed 14 May 2011]. Meltzer, A.H., 1988. Keynes's monetary theory: a different interpretation. Cambridge: Cambridge University Press. Michl, T.R., 2002. Macroeconomic theory: a short course. New York: M. E Sharpe Inc. Quiggin, J., 2010. Zombie Economics: How Dead Ideas Still Walk Among Us. New Jersey: Princeton University Press. Schug, M.C. & Wood, W.C., 2011. Teaching Economics in Troubled Times: Theory and Practice for Secondary Social Studies. New York: Routledge. Tobin, J. & Jackson, P.M., 1989. Policies for Prosperity: Essays in a Keynesian Mode. First MIT Paperback edition ed. Cambridge: MIT Press. Tool, M.R. & Samuels, W.J., 1989. The Methodology of economic thought. 2nd ed. New Jersey: Transaction Publishers. Appendix 1 Double-dip recession in U.S       Percent Change from Preceding Period in Real Gross Domestic Product (annualized; seasonally adjusted);       Average GDP growth 1947–2009 Source: Richard G. Lipsey, K. Alec Chrystal, 2007. Double-dip recession in U.S Appendix 2 a) Contractionary Monetary Policy b) Expansionary Monetary Policy c) Fiscal Policy Source: Richard G. Lipsey, K. Alec Chrystal, 2007. Impact of fiscal and monetary policy on AD Appendix 3 Effect of an Increase of Money Supply on the Interest Rate Source: Krugman, 2009. Effect of an Increase of Money Supply on the Interest Rate Appendix 4 Expansionary Monetary Policy to Fight a Recessionary Gap Source: Richard G. Lipsey, K. Alec Chrystal, 2007. Expansionary Monetary Policy to Fight a Recessionary Gap Appendix 5 How the Expansionary Monetary Policy Works Source: Hubbard, 2007. How the Expansionary Monetary Policy Works. Read More