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The Rise And Fall Of The American Economy - Coursework Example

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Phillips Curve shows the negative relationship between the unemployment rate and inflation rate in the economy. This implies that in order to reduce unemployment, some amount of inflation has to be tolerated or inflation can be reduced at the cost of rising inflation. …
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The Rise And Fall Of The American Economy
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Download file to see previous pages In the US economy, there is a high level of unemployment and the interest rates in the economy are almost down to zero. The inflation is about 2% per year and the Gross Domestic Product (GDP) is increasing at less than 3% per year. It is necessary to raise the GDP growth to about 3% per year while keeping the rates of unemployment and inflation low in the economy. Economic depression in an economy can be controlled by the formulation of effective monetary and fiscal policies. While the Fiscal Policy is administered by the American Government, the Federal Reserve (the Central Bank of America) possesses the power to implement the monetary policies in the economy. These policies are based on a number of laws and theories; Okun’s Law and the Phillips Curve are two such important theories.
The Okun’s law states that when actual output grows faster than potential output, unemployment rate in an economy, decreases and vice versa. The rate of output (GDP) growth corresponding to the stable rate of unemployment is then considered as the growth rate of the economy. Thus, it is the empirical relation between the output gap and the unemployment rate. (House of Representatives, USA, p.44) Phillips Curve shows the negative relationship between the unemployment rate and inflation rate in the economy. This implies that in order to reduce unemployment, some amount of inflation has to be tolerated or inflation can be reduced at the cost of rising inflation. (Tucker, 2011, p.453) Wages was not taken as a component of the Phillips curve as in the presence of unemployment, the bargaining power of labor is almost non-existent and thus, wages cannot be considered a key variable. However, Phillips Curve is a short-run phenomenon and there is no trade-off between inflation rate and unemployment rate in the long-run. (Mankiw, 2009, p.789) These two theories are indispensable to study monetary and fiscal policies because they show the relation between output, inflation and unemployment in an economy. A General Framework: The GDP of a country is the sum total of the values of all the goods and services produced within the geographical boundaries of a country in a particular year. Keynesian economics states that GDP can be expressed as the sum of the Consumption expenditure, the investment expenditure, the government expenditure plus exports minus imports. The equation can be expressed as: GDP = C + I + G + (X – M)…… (1) where C: Consumption expenditure of the households I: Investment expenditure G: Government expenditure X: value of exports M: value of imports Equation (1) represents the real side of the economy where the concerned variables are all real variables. Fiscal Policy: The Government can alter the level of output, consumption, employment and aggregate demand in an economy, using the two main instruments of fiscal policy – taxation and government spending. Keynesian economists believe that fiscal policy has a more straightforward and immediate impact compared to monetary policy (Genovese, 2010, p.160), as it affects the real sector of the economy, rather than the monetary sector. Expansionary Fiscal Policy: Equation (1) can also be expressed in terms of personal disposable income of the household sector as: Thus, GDP = C (y – t.y) + I + G + (X – M) where y: income of the households t: income tax rate in the economy (y – t.y): disposable income of the households Therefore, GDP = C {y (1-t)} + I + G + (X – M)…… (2) When there is a high rate of unemployment in the economy, the Government can reduce the tax level in the economy i.e. the Government reduces “t” in the economy. When “t” is reduced, the consumers are required to pay less amount of their income as tax which increases their disposable income. The household’s consumption expenditure which is a function of their disposable income, naturally record a rise. In the equation (2), as a result of the decrease in ...Download file to see next pagesRead More
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