Contractionary vs Expansionary Monetary Policy - Essay Example

? Economics Economics In most cases, the economy is influenced either through the directive of the chairperson of Fed or the president. These controls in the economy are directed through Federal Reserve use of monetary policy tools that include open market operations, the discount rate, and the reserve requirements while on the other hand, the president gives directives through fiscal policy tools that include either increase or decrease of government spending, tax and subsidies. More than often, these directives are sought to control the upsurge in inflation rates and unemployment levels that hinder the growth in Gross Domestic Product of an economy. With the given case scenario, where the country’s level of gross domestic product (GDP) growth is less than two percent per year and a period that is marked with high unemployment, while the interest rates decreases to almost zero, and an inflation rate at two percent per year there is a need for directives to stimulate economic growth. As a way of influencing the demand and supply of money in the economy, the Federal Reserve use either contractionary or expansionary money policy. Because, the interest rates are low there is a high availability of money supply in the economy as a result, there is moderate inflation occurrence that is currently at two percent. As the Fed chairperson, the use of restrictive monetary policy measures ensure s there is a steady flow of money in the economy during the period (Bartolotti, 2006). This is because restrictive monetary policy ensures that there is a higher level of depository interest rate for commercial banksas it borrows money from the Federal Reserve banks as they keep their reserves at the authorized level. In addition, it is critical to increase the open market operations by ensuring the citizens with extra money to save can invest in it because of the highly expected returns leading to money being drained out of the economy. As a result, the banking institutions will change a higher rate as it lends less money with increased reserve requirement thus, individuals will seek alternatives for seeking funds rather than borrowing money. In addition, the government can make investments with the funds collected from open market operations leading to increased gross domestic product (GDP) growth. With an unemployment rate that is quite high, there is a need to carry out measures that will influence the growth of employment levels in the economy. Concerning, the new classical economists notion on unemployment and inflation, they highly advocate for a stable inflation-unemployment trade-off that is achievable through the Phillips curve. Based on the Philips curve the trade off is achievable on the assumption of changes in the price level in the private sector freely. This is because the Philips curve enhances the relationship between inflation and unemployment because of fiscal and monetary policy changes (Knoop, 2004). Nonetheless, the classical economics argue based on the conceptualization that the expectations-augmented in the Phillips curve emphasizes that the unemployment rate should not extend further than the natural level as it could lead to increased inflation rates. More significantly, it is critical to implement fiscal and monetary policies to influence employment levels (Knoop, 2004). This is because the economy is recovering from a recession period and the economy tends to grow with the aggregate demand (AD) increasing therefore, the levels of employment will increase. Even though, there is an increased pressure for a raise in wages after rescission, the rate at which the economy grows is faster, and the wages begin to rises slowly. Based on the Philips curve an outward shift of the aggregate demand AD curve because of increased consumer spending causes the equilibrium level of national output to shift to the point Y2 beyond potential gross domestic product (GDP). As a result, this creates a positive output gap, and it is more preferably attributed to cause a rise in inflationary pressure as described above. Therefore, the excess product markets and factor markets demand increase causes a rise in production costs as the the short run aggregate supply shifts outwards from SRAS1 to SRAS2. Nonetheless, this leads to fall in supply that reforms the economy towards potential output, but at a higher price level. In addition, the Okun’s law focuses on employment as it allows for price stability in inflation rates that range from zero to two to minimize the effects of inflation costs as a result of market distortion and uncertainty. (Knoop, 2004). On the other hand, when the consumption and the government purchases are increased in the short run it is expected that the aggregate level of demand shifts to the right thus, leading to increase in the gross domestic product. More so, the increase in government purchases causes a downward shift of the price level in the short run. This is because as illustrated in the figure below the initial equilibrium level at point P1 shifts towards point P2 leading to upward rise in the real gross domestic product in the economy, from Y1 to Y3 in the short run (Bartolotti, 2006). Nonetheless, when both the consumption and government purchases levels in the economy increase it goes up, leading to the price levels remaining constant in the long run unlike in the short run period when the price level declines (Mankiw, 2012). Therefore, with the constant price level and the inelastic aggregate supply curve it leads to an upward increase in the gross domestic product in the long run. As a result, the price levels remain constant at P3 because the long run aggregate supply level is price inelastic while the aggregate demand shifts rightward leading to an increase in real gross domestic product from Y1 to Y3 as illustrated in the figure below. Figure 1(Mankiw, 2012) In most instances, as the president it is advisable to use government fiscal policy measures through taxation, government spending and borrowing to influence output, aggregate demand and employment levels. In this case scenario, the employment level is low, an expansionary fiscal expansion that involves a decrease in tax levels with an increase in levels of government spending being essential (Stonecash, et al., 2012). This is because such a fiscal policy will lead to increased demand for commodities. As a result, the producers increase their production capacity by making more investments meet the increasing demand thus, leading to increased employment levels to give the desired output in the market. More so, government can use tax rebates through the company and income tax to influence the economy as the investment tax credit focus on stimulating additional private sector investment. More significantly, tax rebate tool on income tax remains vital to the government as it uses it to stimulate demand for goods and services especially during hard times. In addition, the measure of the magnitudes of macroeconomic policies through the multiplier remains crucial. This is because, the multiplier in economics indicates the level at which the decrease in taxation levels will lead to greater disposable income. As a result, the increased disposable income will lead to increased consumption levels this will cause increased demands levels that exceed the supply levels in the market. More importantly, the producers will employ more labor to meet the unexpected growth in demand leading to increased employment levels (Bartolotti, 2006). More than that, the tax multiplier ensures that the government increase spending of consumers through tax cuts that stimulate an additional demand for consumption goods. Therefore, tax multiplier measures the increase in consumer spending because, of increased disposable income due to tax cuts. More than often, the country’s cannot ignore that it operates in a closed economy because it receives and sells goods and services outside its borders. More so, it is hard to used both fiscal and monetary policies in a closed economy as a way of increasing gross domestic product. Nonetheless, as an open economy country the influences of both monetary policies through increased interest rates and fiscal policy ranging from government spending and taxes influence the economic growth. Many nations experience budget deficits because the government expenditures are in excess over revenues while it has an increased government debt ratio as the deficits accumulate over time. In most cases, the budget deficit-to-GDP ratio is usually negatively and linearly associated with the growth of the gross domestic product based on the per-capita basis. It is therefore, necessary to change the fiscal policies implemented as a way of eliminating the fiscal imbalances (Stonecash, et al., 2012). More so, an increase in taxation would lead to resistance from the public thus, it is vital to decrease the government spending levels in order to achieve growth in gross domestic product despite the likelihood of the economy facing recession. References Bartolotti, L. (2006). Inflation, fiscal policy and central banks. New York: Nova Science Publishers. Knoop, T. (2004). Recessions and depression: understanding business cycles. Westport, Conn: Praeger. Mankiw, N. (2012). Brief principles of macroeconomics. Mason, OH: South-Western Cengage Learning. Stonecash, R., Gans, J., King, S., & Mankiw, G. (2011). Principles of macroeconomics. South Melbourne, Vic: Cengage Learning. 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