Policies towards Achieving Macroeconomic Stability - Term Paper Example

? Policies towards Achieving Macroeconomic Stability due Policies towards Achieving Macroeconomic Stability Introduction The modern world economy is characterized by political governance that is backed up by economic policies. Economic approach is aimed at achieving long run macroeconomic stability that is attaining a stable low unemployment rates, reducing inflation rates in addition to attaining increased rate of economic growth and development. Moreover, unlike in the primitive societies that existed during the birth of economic thought, the modern economy shows instant changes with yesterday conditions being fully different from today’s economic environment. This calls for well thought economic policies otherwise the economy would stump to serious and unsolvable problems in the future. John Maynard Keynes set a good underpinning for government economic decision that has since then be improved by the post-Keynesian economists, through both support and critic of Keynes ideas. It’s on the basis of these foundations that the government sets policies aimed at attaining long run macro-economic policies. Keynesians approach towards stability In establishing a long term s macroeconomic stability, it deems necessary to first understand what causes instability in the economy. Both monetarist and Keynesian economist agree that the world at times suffers from macroeconomic instability as shown by great recessions and booms. However the two economic thoughts differ on the cause and thus advocate for different approaches towards stability. Keynes study was based on aggregate demand and argued that the changes in the components of demand altered the equilibrium (Beetsma 2004). To the Keynesian economists aggregate demand is identical to output levels that can be measured in terms of the Gross Domestic product (GDP). The components of demand are, consumption, investment, export surplus and government expenditure modeled as (GDP =C + I+ X + G= AD). Keynesian economics agreed that these demand components always fluctuate and thus the GDP can never be stable. This formed the main critic of self-adjusting mechanism as brought about the classical economists, with Keynesian economists arguing that investment was influenced by marginal efficiency of capital in addition to interest rates. Thus some savings are not invested as some individuals hoard cash balances if they speculate a rise in capital returns. Another cause of instability as observed by the Keynesian economists are fluctuations of the supply side, where output levels can be altered by artificial supply restrictions, wars, changes in cost of production all which reduce the output levels. All the alterations of the equilibrium call for correction measures, with which Keynesian economist suggest the opposite adjustment of either the government expenditure or consumption component. They thus advocate for discretionary fiscal policy where government expenditure is adjusted or alteration of taxes to reduce or increase overall consumption levels. The Keynesian economists argue that money velocity is unstable and unpredictable in nature and thus disregard monetary policies effectiveness in adjusting in equalizing aggregate demand changes. Moreover, due to frequently changing components of demand; Keynesian economists contempt annual budget adjustments and advocate for discretionary fiscal policies that instantly combat recessions and inflation despite causing surplus or deficit budget. In times of economic recession, when supply is more than demand hence causing reduction in commodity prices, demand has to be created. This is achieved by either reducing taxes or increasing government expenditure. Taxes are seen to reduce disposable income, readily available for consumption. A reduction in taxes increases disposable income and hence increases aggregate consumption. Government consumption on the other hand creates demand for the excess supply. In times of inflation the opposite is applied, that is increased taxes to reduce disposable income and reduced government expenditure. It’s important to note that Keynesian economist do not advocate for self- correction mechanism. In his studies Keynes saw the possibility of the economy correcting itself, but needed a very long time. Moreover, Keynes criticized the theories for self-adjustment as made by the classical economics on the following grounds (Beetsma 2004). Firstly the acceptance of wage cut to reduce unemployment levels seems unrealistic. On the other hand, the employers’ ability to reduce wages is restricted by several factors; to start with the modern economy is characterized by minimum wage levels, labour unions, and employment can be made in terms of contracts. Moreover, higher wages not only increase the incentive to retain a job but also encourages the worker to put extra effort, the increased effort increases output and thus minimizing the firms labour cost per unit output which is in line with the employers objective . The above two conditions make wage inflexible and thus the economy would never correct itself in times of high unemployment rates. Monetarist approach Monetarists on the other hand accuse the government for causing rigidities in the equilibrium. To the monetarists expanded the idea of self-correction, arguing that in a competitive environment, free from government intervention, the forces of demand and supply would act to bring about a substantial macroeconomic stability. They focus on money supply as the major cause of instability come up with a conclusion that if money supply is controlled, inflation and unemployment conditions would be rationalized enabling economic development. Minimum wage lows, pro-union legislation, price floors are some of the government measures that enhance restrict downward flow of prices towards equilibrium (Beetsma 2004). Moreover some government policies are politically influenced and thus mislead the economy. Assuming that velocity of money is stable with gradual and predictable changes, the monetarist argue that money supply is identical aggregate output levels that can be measured in terms of GDP. As first developed by Milton Fried man, the equation of exchange that money supply is equal to aggregate demand expressed as MV= PQ forms the basis of the monetarists. Where, PQ is the nominal GDP. The velocity of money being stable implies that have a stable pattern to spend or hold money balances. Following, the monetarist’s points out that an inappropriate monetary policy is the fundamental cause of instability as alters both an output and price levels (inflation) Following inerratic movement of the velocity of money that prevailed from 1960 to 1980, monetary policies as advocated by the monetarists proved their effectiveness. Even after money supply regulations still worked and thus called for mixed up policies that are use of both monetary and fiscal policies. Following the equation of exchange, and holding money velocity constant, alteration of money supply would influence the nominal GDP. Therefore a correct policy changes money supply would correct output levels as well as prices at full employment. Money supply can be controlled by open market operations, interest rate control an, monetary base control as well as funding but not increased government expenditure or taxation. Monetarist held that an increase in the level of employment increase inflation rates as demonstrated in the Philips curve and thus certain levels of employment and inflation are optimal as zero levels cannot be attained. To this effect an increase in government expenditure in an effort to attain full employment is inflationary. Budget and trade deficits After the onset of global economy, which advocates for minimal restrictions if any to international trade, it has become the objective of every nation to improve on balance of payments. Reducing trade deficits that are the excess of imports to exports in value has become a vital policy. However many governments ignore the impact of persistent budget deficit, i.e. excess of government expenditures to taxes, on trade deficit. Budget deficit implies negative national savings and that lead to government to borrowing. This increases real interest rates in the country and thus attracting foreign investors. Moreover increase in interest rates also have an upward effect on the exchange rates hence leads to increased prices of domestic goods. Both increased domestic prices and attraction of foreign investors yield to increased imports at the expense of exports hence widening trade deficit. In times budget surpluses due to positive differences between tax collection and government expenditure, policy makers can reduce trade deficits. With excess funds, policy makers should strive towards increasing the supply of domestic products in an effort to reduce their prices as well reducing import dependency. Subsidies to essential commodity production are a possible and efficient option. The other option available would be enforcing consumption tax reliefs on domestic products. The two options would reduce domestic prices with the first one aiding quality improvement, hence indirectly influencing imports. Supply side economists and recent economic policies The supply side economists advocated for tax cuts as a method of inducing economic growth through a rise in consumer spending. According to them, tax cuts on income resulted to higher disposable income that increased demand which called for higher production. The higher production will result to increased output as well as demand for higher wages and thus higher amounts of taxes. Following this argument, tax cuts should be employed regardless of the economic conditions. During low inflation rates, tax cuts work very well to increase employment but tax cuts have a negative effect in inflationary times. As a matter of fact, a tax cut only reduces government revenue and well as increasing demand which triggers government expenditure and thus increasing the budget deficit. Of late, economic policies have been formulated to reduce the trade deficit that US has been experiencing. It was in 2010 when Obama set the goal of doubling exports in five years. To effect this government has being working on removing trade barriers in foreign countries reduced barriers to e entry of firms in every industry as this improves quality production through competition. Another policy made by Obama government is to increase revenue collection. Increase tax collection increases government saving which improves trade deficit as discussed earlier. Effect of protectionist Protectionists encourage exports and discourage imports by enforcing trade barriers. As the balance of payment is the difference between exports and imports, the protectionist argue that import barriers such as tariffs should be implemented to maintain low levels of imports. However this restriction has negligible impact on trade deficits based on the fact that restricted imports lower exchange rate, making exports very dear and thus lowering their demand (Elwell, 2007). Moreover regulation on the quantity of both export and import only reduces economic progress that is attributed to specialization. References Beetsma, R. M. W. J. (2004). Monetary policy, fiscal policies, and labour markets: Macroeconomic policymaking in the EMU. Cambridge, UK: Cambridge University Press Chen, P. (2010). Economic complexity and equilibrium illusion: Essays on market instability and macro vitality. London: Routledge. Elwell, C. K., & Library of Congress. (2007). Trade, trade barriers, and trade deficits: Implications for U.S. economic welfare. Washington, D.C.: Congressional Research Service, Library of Congress. National Research Council (U.S.)., National Academies (U.S.), Zhongguo ke xue yuan., & Zhongguo gong cheng yuan. (2010). The power of renewables: Opportunities and challenges for China and the United States. Washington, D.C: National Academies Press. Read More