The Rise And Fall Of The American Economy - Coursework Example

?Running Head: The rise and fall of the American economy The rise and fall of the American economy Part –I Introduction: 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 “t”, the term (1-t) increases and similarly y (1-t) also rises. Now C is a function of the household’s disposable income y (1-t). As the disposable income rises, C records an increase. As the level of consumption expenditure of households increase, this creates a positive impact on the aggregate demand of the nation and it increases. When there is an increase in the aggregate demands in the economy, more goods and services are required to be produced to satisfy this demand. To facilitate more production of goods and services, the economy needs to employ more number of people. As a result, the rate of unemployment in the economy is reduced because actual output level rises faster than potential output level (Okun’s Law) This is known as an expansionary fiscal policy: the Government by reducing income tax rates indirectly raises aggregate demand and production in the economy due to which unemployment is reduced. Similarly, corporate taxes, represented as a part of GDP in the equation given below, can also be reduced to achieve the same results. GDP = C (Y) + I (y1 – t1.y1) + G + (X – M) where t1: corporate tax rate in the economy As a measure of expansionary fiscal policy, similar to the earlier case, the Government can reduce the corporate tax rate ‘t1’in the economy to increase consumption, aggregate demand and thus, the level of unemployment in the economy. Similarly, government spending, signified by ‘G’, can also be used to increase the level of aggregate demand, output level and consumption in an economy. The government can directly invest in the real sector by undertaking massive spending in the public sector, to generate employment. With an increase in job opportunities, output will rise faster than its potential level and people will have more purchasing power as they will earn wages. As a result, the level of aggregate demand and consumption in the economy will rise as well. However, it also has to be mentioned that an expansionary policy cuts into the resources of the government and produces high deficits for it. (Genovese, 2010) Contractionary Fiscal Policy: A contractionary fiscal policy, on the other hand, achieves all the opposite results. By increasing the general tax level, aggregate consumption and hence, the level of demand in the economy falls. Consequently, aggregate supply exceeds aggregate demand and thus, production has to be stepped down. This in turn, leads to a fall in output and a rise in unemployment. However, the budgetary position of the government improves as the increased revenues from taxes exceed the government expenditure. Similarly, a decrease in government spending will translate in to less job opportunities and the reverse circle of expansionary fiscal policies will follow. Contractionary fiscal policies are usually adopted when the economy is affected by a high rate of inflation due to excess of demand over supply. Although these policies reduce government budgetary deficits, they lead to a decrease in overall welfare of the people. Both the theories of fiscal policies comprising of taxation and government spending are based on the Okun’s law. The theoretical relation between output gap and unemployment is empirically proved by the fiscal policy of the government. Monetary Policy: Monetary policies affect the money sector of the economy and Money Demand (Md) and Money Supply (Ms) are the two main concepts here. There are many theories on the transmission channel of monetary policy identifying quantity of money, rate of interest or expectations as the important instruments. The most popular theory on monetary policy has been given by the Chicago School of Economic which considers rate of interest as the instrument of monetary policy. Phillips Curve forms the basic foundation for the formulation of monetary policies. Expansionary Monetary Policy: An economic crisis may also be solved by implementing an expansionary monetary policy that increases the money supply in the market, relative to money demanded. This can be achieved by reducing the rate of interest. As credit flow smoothens, people will have more purchasing power and consumption and aggregate demand will increase. Consequently, production will be stepped up, resulting in a rise in output and a fall in unemployment. However, in the long-run, the increase in purchasing power of people will cause increase in the inflation rate, reducing the welfare effect caused by the fall in unemployment (Belke and Polleit, 2010, p. 738). Contractionary Monetary Policy: Similarly, if money supply is decreased by increasing the rate of interest, purchasing power of people will fall and thus, consumption and aggregate demand will also fall. Production will have to be reduced, cutting output and employment rates. Thus, unemployment level in the economy will rise. Both expansionary and contractionary monetary policies are consistent with the Phillips Curve in the sense that they bring out the negative relation between inflation rate and unemployment rate. In case of expansion in money supply, a high rate of inflation has to be suffered due to a fall in unemployment. In contrast, a contractionary policy ensures a low rate of inflation at the cost of reduced employment. Thus, the increase in unemployment rate can be referred to as the cost of reduced inflation. (Frank, 2006, p. 836) Policy Formulation of the American Government and the FED: The rate of interest observed in the economy is zero. As per monetarists like Milton Friedman, if rate of interest is reduced to zero, the growth rate of the economy improves, by ease in money supply. But, since in the case of USA very little improvement has been observed, it is clear that the economy has fallen into a Liquidity Trap. A liquidity trap is “characterized by a very low level of nominal interest (a minimum point, perhaps, zero)” (Cargill, Hutchison and Ito, 2000, 115), rendering monetary policies redundant. Even direct intervention of the government into the money market by administering money injections will not help. Thus, there is nothing the FED can do by way of controlling money supply and demand that will help the economy to recover. Under these circumstances, an expansionary fiscal policy is the only solution. The high levels of unemployment can be reduced by a massive government spending in the public sector industries like infrastructure, transport and communications, etc. This will lead to a rise in production and thus, a rise in the availability of jobs and the output level (GDP will rise). The excess of actual output over potential output will reduce unemployment, as per Okun’s law. Even though inflation rate is high considering the average inflation in USA, it is not too high at 2 percent. So, even though there is a rise in inflation due to a fall in unemployment, it can be tackled by a monetary policy once economic growth increases and rate of interest comes back to normal. The rise in government deficits can be handled by increasing the tax rates but that is after the expansionary fiscal policy has achieved its target level of output, employment and growth. In case of a closed economy, fiscal policies are more effective in fighting crisis than monetary policies. In fact, monetary policies have no power over output and unemployment when the exchange rate is fixed, as is the case in closed economies. (Van Den Berg, 2010, p.294) Also, Fiscal policies produce better results in closed economies than in open economies where monetary policies are more suitable. In the absence of external shocks, the positive effects of a reduction in tax or an increase in government spending are of higher magnitude. Tax Rebate: A Tax rebate policy of the government is one of the ways in which the US economy can be cured. A rebate in income taxes means that people will have to pay less tax. So, their purchasing power will increase, which will increase aggregate demand and consumption in the economy. This will set in motion the multiplier effect. From the increase in consumption spending, firms will earn more which will increase their consumption and aggregate demand. The final outcome will be a rise in GDP, aggregate demand and employment rate. Similarly, a rebate on corporate taxes will allow producers to spend more on machines equipment and labor force, which will induce higher employment rate and the same multiplier effect, resulting in increase in GDP and AD. (Carbaugh, 2011, p.301) These effects have already been explained in equations (1) and (2). However, a tax rebate will lead to a fall in the revenue of government accumulated through taxes. As a result, government deficits will increase and pose as a threat to the stability of economic conditions. Implications of Growing Budget Deficit on Economic Growth: A high budget deficit is usually bad for the economy since it may compel the government to borrow more on the international market. In case of US, it will add to its already heavy debt burden. Government budgetary deficits are a great setback to the growth of economy. In contrast to this is the case of South Korea, which showed a growth rate of 7.1% in spite of continuous deficits. (Sabillon, 2008, p.123) This may have been due to the fact that it followed export-led growth by pursuing a devaluation policy. Thus, devaluation may be a suitable solution to the problem of budget deficits. Part – II Economic Crisis in the US Economy: The crisis in the US economy originated in the mortgage market. The huge losses in this sector affected the financial institutions that were linked to mortgage markets. Finally, the economic depression was transmitted to the real sector of the US economy affecting output levels, employment levels and inflation rates. Other countries in close conjunction with the US economy suffered the same fate, too. Adoption of the flawed fiscal policies by the American government and flawed monetary policies by the FED, together contributed to the collapse of the world’s greatest economy, the US. An analysis of the existent monetary and fiscal policies will highlight the faults in them and also show how they led to this economic massacre. Fiscal Policies: Even though monetary policies of the US FED were to be blamed primarily for the Economic Crisis of 2007, fiscal policies or rather lack of it, has accelerated the process. In the words of Ben Bernanke, “Faster economic growth, Bernanke went on, depends on fiscal policy, and the design of intelligent tax and spending programs’. (Jubakpicks, 2011) This statement represents the importance of fiscal policies for an economy. The US government had largely followed a contractionary fiscal policy with high tax rates and very little investment in the real sector. This was primarily due to the fact that almost all the sectors in the US are privatized. Hence, the government does not need to invest in them. On the other hand, high taxes were charged on these sectors, through income as well as corporate taxes. The US government budget is divided into a current account and a capital account. Under normal conditions, the current account is financed by taxes and the capital account, by loans from the international market. This is the reason for the high debt incurred by USA. In times of prosperity, both the current account as well as a portion of capital account will be financed by taxes and in times of economic depression, along with the capital account, a part of the current account will be financed by loans as well. (Buti and Franco, 2005, p.8) So, the bottom line is that the US government has always shown a strong tendency towards loaning, with little amount of resources or willingness to spend on public undertakings. Simultaneously, it had extracted huge sums in taxes from the populations and firms. These contractionary fiscal policies pursued at an aggressive level, has contributed towards the economic crisis. Monetary Policies: Where fiscal policies were known for their contractionary effects, monetary policies were extremely expansionary. The FED expanded money supply inside and outside of US by tenfold since 1990, utilizing the full benefits of the regime of globalization. This has been achieved by maintaining a low level of rate of interest in spite of the huge money supply in the economy. The over-expansion of money supply in the mortgage markets were due to the lack of imposition of proper rules and regulations in the money market, by the General Services Administration (GSA). Money supply should expand as per the GDP growth rate and inflation rate of the economy, which is a low value of 2-3 percent. As per this calculation, the money supply should have increased from $600 billion to $913 billion in 17 years. However, the FED extended this quantity to $6,000,000,000,000. The value of the US Dollar became super-inflated and there was an increase in foreign investment in US stocks. (Kim, 2008, p.178) The non-perusal of a devaluation policy led to a fall in exports and a rise in imports, causing huge trade deficits in trade balance. This adverse conditions of trade, combined with the over-valuated Dollar and expansionary monetary policy finally brought down the US economy. Policy Solutions to the Crisis and their Effects: Since the root causes of the economic crisis in USA was a flawed combination of monetary and fiscal policies, the solution lay in the correction of these policies by replacing them with more effective policies. However, the US government still does not seem to have been successful in producing the right mix of monetary and fiscal policies. Fiscal Policies: Considerable resources have been spent by the government as fiscal stimulus to extract the economy out of the economic crisis but this spending has been mis-directed. Fiscal policies should be aimed at the real sector of the economy to attain optimum results. The positive effects of a fiscal policy on the output level, consumption and aggregate demand can be best explained with the help of the Permanent Income Hypothesis. It states that the consumption of a person depends on his permanent disposable income. Permanent income implies the current income of the person plus the average of his income in the next successive years. (Agarwal, 2010, p.111) Effective fiscal policies guarantee stability in employment and thus, permanent income to individuals. This increases their purchasing power and hence, aggregate demand and consumption, finally resulting in increase in GDP growth of the economy. However, the fiscal stimulus of the US government has been concentrated on saving the monetary sector. Through the Troubled Asset Relief Program (TARP), the government had bailed out loss-suffering financial and banking institutions by purchasing their assets and equities. These are a form of liquidity injections and are non-productive in nature. The favorable effects from this investment will, at best, save the institutions from bankruptcy but it cannot be transmitted to the real sector. So, there will be no improvement in the state of output level, aggregate demand, consumption and employment generation. However, the US government had adopted a Tax Rebate Act of $168 billion and a $787 billion Act on Government Spending and Tax Rebate between 2008 and 2009. (Saw, 2010, p.56) These two policies may have desirable effects on the real sector and generate demand in the economy. An analysis shows that the majority of the fiscal policies of the government have not been successful in the short run. Investing in the bail-out of financial institutions has resulted in the misallocation of government resources. However, in the long run, the beneficial effects of the tax rebate policies and increase in government spending may rescue the economy out of economic doom. But, in order to achieve that the amount of government spending has to be massive. Monetary Policies: The collapse of the US economy should have been followed by dear money measures but monetary policies seem to be as loose as ever. It is true that in the year 2009, an expansionary monetary policy helped in accelerating economic growth and aggregate demand but, these measures are preventing the inflation rate from falling. Inflation rates are at an all-time high and the most effective way to bring it down to a moderate level is by following a contractionary monetary policy. This is being overlooked by the FED due to the negative effect it may create in economic growth. However, a proper vigilance is being maintained on price developments, foreign exchanges and inflation. Another area in which the government must initiate action is deficit financing of banks. Under the current circumstances, the government must completely avoid deficit financing of banks. (IBP USA, 2011, p.200) However, this not the case as the US government seems too eager to protect the monetary sector from being affected. It almost seems as if the US government is obsessed with its monetary sector, sacrificing the real sector to save the money market. Although the monetary measures adopted are not as effective as needed to reverse the adverse effects of an economic depression, they are well addressed and performing better than the fiscal policy. However, the point is that with extremely low rate of interest, the economy is caught in a liquidity tarp. Therefore, monetary policies are not of prime importance any more. They can achieve little in the absence of flexibility in its key variable, the rate of interest. Tightening of rules and regulations in the money market, especially the mortgage market is much needed with an optimum level of tightening of the monetary policy. In the short run, there is not much that lies within the power of monetary policies as the economy is way past the situation when monetary policy still could have been effective. So, the question of its effectiveness in the short run is not an issue. In the long run though, the increased rules and regulation and monitoring of the money market may prove to be fruitful. And, the expansionary monetary policy may prove to be successful in raising GDP, in the long-run, by an increasing purchasing power, consumption and aggregate demand in the economy. With time more effective monetary policy can also be adopted as the rate of interest comes back to its normal value. Conclusion: The US government needs to reconsider its decisions on monetary and fiscal policies, in order to fight the adverse effects of economic downturn manifested in low GDP, low Aggregate demand, low consumption, coupled with high unemployment and inflation. Flaw in the formulation in these policies has incited this depression and a correction of the same is the only way out of this problem. Even though some of the policies have been well targeted and the government had spent considerable resources, still much remains to be addressed and achieved from formulation of monetary and fiscal policies, as is evident from the current state of the economy. References: 1. Agarwal, V. (2010). Macroeconomics. India: Dorling Kindersley Pvt. Ltd. 2. Belke, A. & T. Polleit, (2010), Monetary Economics in Globalised Financial Markets, Springer 3. Buti, M. and Franco, D. (2005). Fiscal policy in Economic and Monetary Union: theory, evidence, and institutions, USA: Edward Elgar Publishing, Inc. 4. Carbaugh, R.J. (2011). Contemporary Economics: An Applications Approach, New York: M.E. Sharpe, Inc. 5. Cargill, T.F., Hutchison, M.M. and Ito, T. (2000). Financial Policy and Central Banking in Japan, USA: Massachussetts Institute of Technology. 6. Frank, (2006) Principles of Economics, Tata McGraw Hill 7. Genovese M. A. (2010). Encyclopedia of the American Presidency, USA: Infobase Publishing. 8. House of Representatives, United States (2005). United States Congressional Serial Set, USA: US Government Printing Office. 9. IBP USA (2011). Solomon Islands Foreign Policy and Government Guide, USA: IBP Publications. 10. Jubakpicks (2011), If Washington cannot do anything about Jobs and Infrastructure now, Jubakpicks, retrieved on September 15, 2011 from: http://jubakpicks.com/2011/09/06/if-washington-cant-do-anything-about-jobs-and-infrastructure-now-can-it-every-do-anything-about-jobs-i-think-the-answer-is-no/ 11. Kim, J.S. (2008). Confessions of a Wall Street Insider, USA. 12. Mankiw, N.G. (2009). Principles of Economics, USA: South-Western Cengage Learning. 13. Sabillon, C. (2008). On the Causes of Economic Growth: the Lessons of History, Shanghai: Algora Publishing. 14. Saw, S.H. (2010). Managing Economic Crisis in East Asia, Singapore: ISEAS Publishing. 15. Tucker, I.B. (2011). Macroeconomics, USA: South-Western Cengage Learning. 16. Van Den Berg, H. (2010). International Finance and Open-Economy Macroeconomics, Singapore: World Scientific Publishing Co., Pvt Ltd.   Read More