Can the Government Stabilize the Economy - Assignment Example

Can the Government Stabilize the Economy? Section Long-run Economic Growth What are scarce resources and how can a country use these to grow their economy? How important is productivity to long-run growth in an economy and what does productivity consist of? Has international trade impacted the U.S.A. long-run economic growth? If so, how? The last time the United States economy was in a surplus was in the mid-1990s. Pretend you are an economist. What would you recommend for economic growth for the United States economy? Scarcity of available resources constrains all economic decisions of individuals, household, firms, and governments. . Such scarcity, whether natural or man-made, makes it necessary for everyone to stretch whatever limited resources he has. Resources can be financial or physical. Practically every one has to make hard choices, to make trade-offs as between one good or service and another. A decision to have one or more of one thing means that one will have less of something else. The relevant cost of any decision is its opportunity cost- the value of the next best alternative one has to give up. Economists stress that one must always calculate the opportunity cost of any specific choice. It would be an ideal situation if a policy maker had all the resources with which to grow the national economy. Scarcity is not the basic premise of growing an economy but rather the availability and the optimal utilization of resources. A country such as the United States has considerable amount and diversity of resources such that it can become self-sufficient; however, less naturally endowed countries would have to grapple with dire scarcity to some degree and will have to procure resources other countries. In a particular case where a country has to consider only what resources it has within its national borders, it will have to make choices about how to use them to maximize or optimize production. In a simplified production possibility frontier (PPF) model where a country has limited resources and a given technology and has only two outputs from a fixed supply of inputs, the decision maker has to make decision about the various combinations of the two outputs, such as wheat and soybeans, or foodstuff and computers. The production of food alone and none of computers will likely not use the resources available in an optimal way. The ideal combination might lie between the two extremes where a certain proportion of resources are employed for the production of food and computers jointly. The concept of the production possibilities frontier comes to our mind – it shows the different combination of goods that a producer can turn out, given the available resources and technology (Baumol and Blinder 1997). In a liberalized international economic system, an economy may also engage in export and import trading in order to benefit based on the theory of comparative advantage. Productivity. Productivity is maximized if a firm in the convex production possibility frontier model operates within the attainable region inside the PPF, and most efficiently on the border, where resources are adapted to the production of both goods, as too much specialization can mean the loss of at least part of their productivity. Fig. An example of a Production Feasibilities Frontier involving the production of food and/or computers. The position and shape of the production possibilities frontier that constrains economic choices are determined by the following: 1) physical resources, 2) its skills and technology, 3) its willingness to work, and 4) the stock of built up infrastructures and factories, and 3) its assets of research and innovation (See Baumol and Blinder, 1997). Opportunity cost. Opportunity cost, as mentioned above, is the value of the next best alternative that one has to give up when making a specific decision. An opportunity cost is always implicit in every decision, whether made by an individual, a firm, or a government. When a government draws up a budget and allocates funds to specific projects, some other projects are sacrificed in the choice. A program of growth. An economy that seeks to grow must allocate scarce resources between current consumption and future growth. Steel and cement could be used for the construction of swimming pools and auditoriums but they could also be diverted to the construction of factories and machineries and infrastructures. Grain that could be consumed could be used as seed to expand planted areas. By deciding how large a quantity of resources will be devoted to consumption and how much to future growth, an economy chooses how fast it wants to grow. By making the decision of producing more capital goods and relatively less of consumption goods, it may be able to expand the production possibilities frontier outwards, a shift which implies the society is able to produce more of both of the combination outputs seen on the graph. But such a choice of course involves an opportunity cost – the sacrifice of welfare because of reduced current consumption. The most efficient combination of the allocation of resources would likely be on any point on the frontier, as anywhere else is either impossible (outside) or a waste or resources (inside). International trade: Impact on the US economy. It is axiomatic that a country that engages in international trade benefits from the transactions because of the law of comparative advantage. In fact the World Trade Organization exists on the basis that international trade improves productivity, output, and welfare for those societies that participate in free trade and that rules and disciplines must be established to bring it about in an efficient manner.. The U.S. has been running a trade deficit as well as current accounts deficit for 20 years or more. In the trade balance report of the Bureau of Economic Analysis, the volume of U.S. trade in goods and services have been considerable with total imports always exceeding exports since 1992. The U.S. Trade deficit rose from $39 billion in 1992 and progressively rose every year, reaching nearly tenfold in 2000 with $380 billion and again nearly doubling to $700 billion in 2007.This occurred against the backdrop of robust economic expansion which lends support to the argument that a trade deficit is not necessarily a bad thing a bad thing (US trade balance.). Most of the balance in trade by foreign countries consist of billions of dollars worth of holdings in U.S. Treasury securities, attracted by high interest rates and the stability of the purchasing power of the dollar. The risk would be when the US dollar loses that advantage and foreigners would withdraw their funds, which could cause the US dollar to drastically drop in value. Economists measure the value of its deficit in relation to the Gross Domestic Product, and this means that the deficit can be allowed to expand for as long as the GDP keeps rising. My Advice as an Economist. I would advise our policy makers to create policies that would raise savings and investment in the U.S. economy. This will enable an increase in the amount of capital, trained labor, and the level of technology. There should be more infrastructures such as highways, roads, bridges, airports, schools, and improvement in the capability of government institutions to respond to problems of the economy. We should encourage more investments in plant and equipment coupled with increased trade with foreign countries. At the same time, a certain amount of restraint may be necessary because by curtailing current consumption to a considerable degree, it might trigger discontent and possibly endanger the position of incumbent political leaders in leading the economy. It is also necessary to balance investment-oriented policies with attention to current social needs. As to the proper mix between economic and social policy, this is for the politicians and the citizenry with its voting power to decide. Section 2 Fiscal Policy Discuss Fiscal Policy. What branch of government can influence Fiscal Policy? Can the Federal Reserve Bank influence Fiscal Policy? If so, how? Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy? The two types of government spending are purchases of good and services and government transfers. The two big items in government purchases are national defense and education. The big items in government transfers are Social Security and health care programs. According to Investopedia, fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nations economy. It is the sister strategy to monetary policy, by which a central bank influences a nations money supply. These two policies are used in various combinations in an effort to direct a countrys economic goals. Here we take a look at how fiscal policy works, how it must be monitored and how its implementation may affect different sectors in an economy. Fiscal policy is made by the President and the Congress on an annual time line that begins in January of each year when the President submits his budget proposal to Congress. Congress debates, amends, and enacts the budget starting in March of the fiscal year. Fiscal year begins in September.(See Parkin, 2000). Expenditures, tax revenues, and the budget deficit are the main bases and determinants of any years budget. Assisting the President in the budge preparation process is the Office of Management and the Budget. The Congress has budget committees in both houses that provide staff support during its deliberations and debates. Although fiscal and monetary policies have the same objectives of promoting economic growth and controlling inflation, the fiscal branch and monetary branch (the Federal Reserve Board) work independently. The Fed lays down policies concerning the reserve requirements of the commercial banking system, engages in open market operations (the buying and selling of Treasury securities), and the setting of discount rates for the banking system. The Fed is independent, a characteristic that ensures that policies are not influenced by politicians and pressure groups, which if followed could prejudice the national interest. The Fed can influence fiscal policy in some rare cases and indirectly. In extraordinary times, it can print money to supplement shortfalls in the federal budget provided it does not result in subverting the economy by creating inflation. It will probably used during recession when the economy needs stimulus. Indirectly, the macroeconomic policies that create expansion or contraction in money supply can cause corporate and private incomes to vary so that more taxes can be collected when incomes rise, and less taxes are paid when incomes fall during recession and a period of high unemployment An expansionary policy is one that seeks to increase government purchases of goods and services or a decrease in tax revenues (tax cuts). This policy was followed during the Reagan administration with his supply-side economic policy (Parkin, 2000; Mankiw 1997). An expansionary fiscal policy has the effect of increasing money supply and encouraging both consumption and investment within the economy through a process called multiplier. An expansionary policy is advisable when the economy is stagnant or growing slowly, when the unemployment level is high, or when there is a recession. The higher unemployment compensation during recession automatically helps in stimulating the economy. Consistently with the Keynesian theory, governments can "borrow" from the future by incurring a budget deficit and can having a budget surplus when the economy is doing well. The so-called counter-cyclical spending programs would drive the budget into a deficit (Sommers, 1993). A contractionary fiscal policy is one where there is a decrease in government purchases or an increase in taxes (Parkin, 2000). This would help moderate an economy that is overheating or reduce/control the rate of inflation. Payments from the Federal budget consist of purchases of goods and services and government transfers. Both of these expenditure create an impact on money supply as purchasing power is infused in the economy to the suppliers of goods and services and to people who receive pension and retirement payments, unemployment and welfare payments, medicare, medicaid, and others. Government transfers to foreigners will have stimulative effect on the receiving economies but none as far as the United States is concerned. The US government has experienced fiscal deficits for many years, recently htting $438 billion, and the national debt reaching $10 trillion(US budget deficit; Bittle and Johnson). These developments have not affected inflation. In fact the US economy has been growing amid huge annual fiscal deficits, and seems to be inflation proof. Section 3 Inflation, deflation, and stagnation Discuss inflation, deflation, and stagnation. Someone who never took a macroeconomics course might say if the United States is in a deficit why they dont just print more money. As a student taking macroeconomics what will be the impact if the United States started printing money to cover the deficit? What is hyperinflation and what causes it? What is deflation and what causes it? What is stagnation and what causes it? The united States experienced three recessions in the late 1980s and early 1990s, when was the last thime the United had a recession? Provide example with references. In order to understand inflation, one has to recall some basic concepts about money. Money is a store of value, unit of account or medium of exchange. The central bank (i.e. the Fed in the U.S.) has the responsibility of controlling the supply of money. The quantity theory states that nominal GDP is proportional to the stock of money. Because the factors of production and function determine the real GDP, the quantity theory implies that price level is proportional to the quantity of money. Thus the rate of growth in quantity of money determines the price level (See Baumol and Blinder, 1997). Inflation is defined as the continual increase in the overall level of prices (Colander, 2001). Fear of inflation prevents a government from using macroeconomic policy, such as lowering interest rates, in order to expand the economy and reduce unemployment. It is also a highly charged issue that can have repercussions on the career of elective political leaders. Policies that promote long-term growth are often subordinated to short-run concerns about rising prices. The inflation rate is measured by the price indexes, the most commonly used being the Consumer Price Index (CPI), published by the Bureau of Labor Statistics. The CPI represents the value of a basket of goods and services of the current period as compared to a base year such as 2001. Reading the inflation data may be meaningless unless one compares them with the growth in average personal disposable incomes. The purchasing power of the dollar through a period of time is the real measure of consumer wealth and welfare. Inflation can be caused by the increase in the prices of imported goods, such as energy products and some commodities, resulting in imported inflation. This happened in 1973 and later in the early 1980s. Inflation can be caused also by increasing demand for goods and services vis-a-vis lack of corresponding increase in productivity. A greater volume of money supply created through through monetary and fiscal policy and through the governments power to print money may create greater wealth on the part of households and individuals, thus causing demand-pull inflation. Deflation is defined as the decrease in the overall level of prices. Historically, deflation is known to have been experienced during the Depression when prices fell 25 per cent. This was attributed to the decline in money supply caused by high unemployment and depressed income. Economists argue that deflation causes an increase in real income for holders of real money balances. According to the Pigou effect, as prices fall and real money balances rise, consumers should feel wealthier and should spend more (Mankiw, 1997). This situation could automatically help restore the economys ability to collect itself. A deflation is not expected to occur unless the situation similar to the 1930 depression can happen, which is very unlikely. Stagnation occurs when the economy does not improve, when there is zero or negative growth in the Gross Domestic Product, without taking prices into consideration. Stagflation is a situation of falling output and rising prices - a combination of stagnation and inflation. A disinflation is a reduction in the rate at which prices are rising, for example when inflation rises 6 per cent and drops to 4 per cent the following year.. A recession can be less worse than stagnation because it just implies that the GDP has not grown for two consecutive quarters. A depression is a very severe form of recession, the likes of which has not been experienced for more than 70 years. When the government prints money When a government or its central bank prints money in a wanton manner, hyperinflation can result. Hyperinflation is defined as inflation which exceeds 50 per cent a month, or more than 1 per cent a day.(Mankiw, 1997), or when it hits triple digits or more per year (Colander, 2001). The last time the United States had hyperinflation was during the Civil War; in contemporary times, we have witnessed hyperinflation in such countries as Israel, Bolivia, Brazil and Argentina. During hyperinflation, money loses its value very rapidly, so that income or salary earners devote a lot of time managing their cash instead of being productive at work. This causes the economy to run inefficiently. Stores and suppliers have to change prices frequently. Taxes also lose their value because of the tax payment schedules lag behind the times income is earned. In a worst case situation, one could carry more paper money to exchange for a lesser volume of goods. The ultimate outcome is for barter to become the mode of exchange, paper money having lost all of its value. Hyperinflation occurs when governments have inadequate tax revenue with which to pay for its spending. The alternative of issuing debt may be eschewed when it is unable to borrow because lenders consider the government to be a bad credit risk. The only alternative left is to print money, which leads to hyperinflation, which in turn leads to larger budget deficits, which leads to more printing of money. This vicious cycle can only be arrested when the government musters enough political will to stop printing money and focus on collecting taxes. Recessions. According to the Progressive Policy Institute (2008), the worst recorded U.S. recessions, in terms of real-dollar GDP contraction were as follows: 1932: -13.0% 1930: -8.6% 1931: -6.4% 1938: -3.4% 1982: -1.9% The United States had a recession in the early 1980s as a result of the Iranian revolution that had started an energy crisis earlier, in 1979. This was coupled with tight monetary policy in the United States to control inflation which had begun in 1973, when economic activity fell. It lasted sixteen months. In the early 1990s a recession that lasted eight months was caused by a slowdown in manufacturing, ending in March 1991. The third recession -- the last time the United States had a recession -- began in 2001 and lasted eight months from the start of the downturn to the start of the recovery (Feldstein, 2008). This was caused by the collapse of the dot.com bubble, the September 11 attacks, and the accounting scandals. Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, attributed these recessions to deliberate Federal Reserve policy aimed at reversing a rise in inflation. The Fed raised real interest rates to trigger an economic slowdown that would move the economy back toward price stability. Then interest rates were reduced in order to bring end the recession. The United States is on the threshold of another recession that is probably more difficult to solve from the viewpoint of macroeconomic policy than ever before because interest rates had been low when the present crisis occurred. The cause of the present problem can be found in the subprime mortgage loan problems, with the concomitant decrease in house prices and reduced household wealth, and the inadequacy of supervision by by the Fed to prevent it from developing in the first place (See Feldstein 2008). REFERENCES Baumol W. J. & Blinder, A.S. (1997). 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Answers.com Retrieved November 20, 2008, from http://news.bbc.co.uk/1/hi/business/3430405.stm Consumer Price Index. Bureau of Labor Statistics. Retrieved November 20, 2008, from http://www.bls.gov/news.release/cpi.toc.htm Feldstein, M. (2008, February). Our Economic Dilemma. Retrieved November 20, 2008, from http://www.nber.org/feldstein/wsj022008.html Fiscal policy. Retrieved November 20, 2008 from http://www.investopedia.com/articles/04/051904.asp Fiscal policy. Answers.com. Retrieved November 20, 2008, from http://www.finpipe.com/fiscpol.htm Gross domestic product. Bureau of Economic Analysis. Retrieved November 20, 2008 http://www.bea.doc.gov/bea/dn1.htm Recessions in US history (2008, October). The Progressive Policy Institute. Retrieved November 20, 2008, from http://www.ppionline.org/ppi_ci.cfm?knlgAreaID=108&subsecID=900003&contentID=254799 U.S. budget deficit hits record $438 billion for year. 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