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MARKETS AND THE ECONOMY - Assignment Example

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Increased federal budget deficit resulting from a recession helps stabilize an economy During a recession the federal budget deficit can increase due to some automatic stabilizers in the economy and/or due to deliberate higher government spending to boost the economy…
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Download file to see previous pages... The factors explaining the increase in budget deficit stabilizers are outlined below: 1) As the economy goes into recession, corporate profits decrease leading to lower corporate tax revenues for the government. Due to lower demand in the economy, companies sell less and have higher cost pressures leading to lower profitability. 2) As corporate profit decrease, companies start firing employees leading to an increase in unemployment in the economy. This further leads to lower income tax revenues for the government. 3) As unemployment increases, the government has to make more payments for unemployment benefits and other welfare programs (transfer payments). These three factors automatically increase the government deficit during recession due to lower revenues and higher spending built into the system. 4) In order to spur demand in the economy, government can spend higher than usual. This spending could be through lowering taxes and/or increasing spending on new/existing projects. All the four factors combined mean that some of the effect of recession on households and companies is mitigated by government spending. Unemployed workers get state benefits and companies get opportunities to invest in new projects. The combined effect is that companies are encouraged to hire more workers to work on those projects thus reducing unemployment and people have more disposable income due to reduced taxes thus increasing consumption. Therefore, the increase in budget deficit during a recession helps stabilize the economy by bringing it back to the equilibrium operating level. Adjustments in wages and prices take the economy from the short-run equilibrium to the long-run equilibrium The price system and wages in the economy do not always change instantaneously. Changes in macro-economic factors like output, demand, supply, interest rates etc do not immediately bring about a change in price levels and wages. Thus, when one or more of the other macro-economic variables changes in the economy, prices and wages are slow to react to this change, therefore the economy comes to operate in a short-run equilibrium where prices and wages are yet to adjust to the other macroeconomic changes. Some of the reasons for this stickiness of prices and wages include contracts for fixed duration like labor union contract for wages fixed for a year, or even market competition prohibiting firms from increasing prices suddenly. However, as time goes (in the long-run), wages contracts get re-negotiated depending on earlier changes in demand and supply, inflation, and other factors. This change in wages leads to change in cost structure of firms and price changes then become necessary. For example, if the labor union re-negotiates to higher wages, the firm must increase its prices in order cover the increased cost of labor. As these adjustments in wages and prices take place, the movements of wages and prices determines the output of the economy. For example, if the firms find it less profitable to produce more, the will reduce their output and the GDP will contract and vice versa. Thus, adjustments in wages and prices take the economy from short-run equilibrium to long-run equilibrium. This is to say that if the prices and wages had changed immediately following a change in the other macroeconomic factors, the long-run equilibrium output would have been seen in the short-run. However, as prices and wages are sticky and adjust to the changes slowly, the economy first settles on a short-run equilibrium where other factors have changed but prices and wages have not and eventually the adjustments in price and wages takes the economy from t ...Download file to see next pagesRead More
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