LR growth, Economic Fluctuations, US Stabilization Policy - Term Paper Example

LR growth Robert Solow is one of the neo ical economists who believed that growth of output leads to economic growth and economic development. According to the Solow model, growth output is dependent on increase in the factors of production and mostly increase in the labor quality and quantity. In addition, increased capital which is dependent on savings and investment also leads to increased growth in output as proposed by this theory. In this theory it is assumed that technology is constant across countries. Improvements in technology also attribute to the growth of output, thus economic growth development. Differences in the rate of technological advancement can be attributed to the difference in capital stock in a country. A diagram to illustrate Solow theory Economic development Level of capital stock According to this theory, the difference in the level of economic growth and economic development can be explained by variations in capital stock among countries as show cased by the diagram above. This notion of convergence as postulated by Robert Solow implies that states will provisionally converge to a certain level of income. This is based on the assumption that capital is assumed to flow from areas of high capital- labor ratio to countries of low capital-labor ratio. This has the implication that cross- country difference in the level of GDP can be explained by the different levels of capital stock. From the above discussion it cannot be disputed that the differences in levels of capital stock between the developed countries like USA and the Western Europe and developing countries in the sub-Saharan Africa leads to differences in economic development. In this paper, we will consider countries like Zimbabwe, Rwanda, Kenya and Somali to compare the level of economic development in these countries to that of USA and Western Europe. The actions of these countries’ national governments determine level of capital inflows that these countries experience. In these sub –Saharan countries, they often experience political unrest like the post election violence that happened in Kenya in the year 2007/2008. These areas are also war prone, for example, the 1994 Rwanda genocide and the civil war currently in Somali. In addition, inadequate financial institutions, political instability, high level of risk, and dictatorship in governance like showcased by Zimbabwe inhibit economic development. The above discussed factors inhibit capital inflows into the developing countries. This offers an explanation why the developing world will never economically develop as compared to the developed economies. Lastly, the policies of these countries discourage domestic saving, thus lowering the rate of capital accumulation. The reduced domestic savings leads to low level of investment. thus reduced level of capital stock in the countries. An increase in the level of savings increases the total output in the short-run, but in the long run it increases the ratio of capital to labor thus leading to decrease in returns on capital. This in turn results to capital outflow instead of inflow. Economic Fluctuations The phrase business cycles refer to economic cycles or fluctuations that are experienced by economic activity of a certain state. There two main theories that have been propagated to explain how business cycles work; New Keynesian and the real business cycle theory, these two theories differ a lot as discussed below. New Keynesian models New Keynesian models view, business cycles as reflection of a possibility of the economy being in equilibrium in the short run where such points of equilibrium are above or below the full employment level. Therefore, when the economy is operating below the full employment level, then unemployment arises. New Keynesian economist believes business cycles results from fluctuations of effective demand. Effective demand can be classified as consumption demand and investment demand that is amount resources demand for consumption and for investment and these composes the aggregate demand. Effective demand is determined at the position where the aggregate demand is equal to the aggregate supply. Therefore Keynesian economist believed that there need to stabilize the economy and thus, the need employ monetary policy when fluctuations arises. New Keynesian economist argued that at times of excess demand that is when there is higher inflation because of too much in circulation. There is need for minimum government intervention to stabilize the economy through monetary policy to stabilize the economy by employing measures that are discretionary in nature. New Keynesian models mainly rely on the factors influencing demand such as rigidity of wages and prices to explaining business cycles. They propose that, a boom in the economy lower prices thus higher demand. Graph showing wages rigidity as postulated by the new Keynesian models, thus increase in unemployment. ND NS W* N In the above graph W* is the wage rate in the market, ND is labor demand and NS labor supply. Real businesses cycles Real businesses cycles proponents, believes on the notion that, supply creates its own demand. They argue that an economy should pay more attention to the supply side, formulating policies that enhance the productivity of an economy. In addition, they believe that economic shocks experienced are real and can be spread over time. In contrast to the new Keynesian models they believe, economic fluctuations emerge due to changes in economic environment, such as technology. The proponents of real business cycles argue that technology is the source of economic shocks. Unlike the new Keynesian models, real business cycles proponents argue that there business cycles are real and they do not reflect cases of market failure, where the market fails to clear as it is the case of Keynesian theories. Real business cycle proponents argue that, there is no need for government intervention through monetary or fiscal policy in order to stabilize the economy. The government should muse on long-term structural policies changes. Therefore, they propose some certain prepositions that include, lowering the level of income taxes as wells tax rates on capital gains, reducing regulations and lowering barriers in production of goods and services. USA stabilization policy Macroeconomic fundamentals usually affect the stability of the economy. An economy is at equilibrium when the aggregate demand is equal to aggregate supply. Aggregate demand is composed of the consumption, government spending, exports and investment, while the aggregate supply components are taxes, savings and imports. At the equilibrium, the economy experiences full employment. When the employment is above or below the equilibrium, the federal government in order to achieve full employment engages both fiscal and monetary policy to stabilize the economy and achieve full employment. Fiscal policies are techniques used by the governments to control the aggregate demand while the monetary policies are tools used by the central bank to control the amount of money that is in circulation. Through these two vital tools, the government is able to stabilize the macroeconomic variables such as unemployment, inflation and foreign exchange. Fiscal policy may be contractionary or expansionary; contractionary fiscal policy refers to a situation where the government uses fiscal policy to discourage consumption this is done through reduction of disposable income available to consumers. PRICES AD2 AD0 AS 0 E2 E0(FULL EMPLOYMENT) E1 OUTPUT/EMPLOYMENT Fiscal Expansionary policies are actions taken by the government to increase induced consumption through increase in income disposable this is done through the increase in the level of government spending or decrease in taxes levied on consumers. Usually, when the government increases spending or lowers taxes, this makes the aggregate demand to increase, which is reflected by shift to the right by the aggregated demand curve. When aggregated demand increases this induces firms to increase their supply in the market to match the increased demand due to the increased purchasing power by the consumers. This makes firms to demand more laborers so as to increase production, this increase the level of employment in the economy. This is illustrated by the above graph where a shift from AD2 to AD0, thus the economy is at equilibrium and also full employment. Therefore, in order to increase economic growth in the country and increase the level of employment in the economy the government should implement expansionary measures thus the government should increases its expenditure and also reduce taxes. This will induce investments thus increasing the aggregate demand. In addition, this action by the government increases the level disposable income thus increasing consumption. The overall effects of the government action will be increased economic growth and increased employment level in the economy. Although critics of this policies argues that this would increase the level of inflation in the economy, since when government increases it expenditure this would imply that the action by the government would increases the amount of money in circulation thus inflation. I would support fiscal expansionary measures, since increased government expenditures do not necessarily lead to increase in the level of inflation. This based on the argument that, increased government expenditure will trigger increase in the level of investments. The second policy that the government uses to stabilize the economy through the central bank is the monetary policy. There are various tools that the central bank can use to stabilize the economy which includes; open market operations, reserve requirements, lending rates, moral suasion. The most appropriate tools in this case would be the open markets operations and lending interest rates. In this case, the government securities earlier sold to investors should be bought back so as to increase the money circulation. This will makes the investors invest in various sectors of the economy, thus creating employment opportunities. The lending rates that the central bank extends credits to the commercial banks should be lowered so as to make funds available to investors at lower interest rate. This encourages investors to borrow and invest the funds in the various sectors of the economy. This increases the level of employment in the economy, thus improving the level of economic growth experienced. Although opponents of the above measures argue that the amount of money in circulation will increase thus eroding the value of the domestic currency. This measures will triggers investments that will offset effects of increase in money supply. Read More