Expansionary Economic Policy to Move the Economy out of Recession - Research Paper Example

EXPANSIONARY ECONOMIC POLICY TO MOVE THE ECONOMY OUT OF RECESSION In order to take the economy out of a depression, the federal government would connect in expansionary economic strategies. The government would undertake expansionary fiscal and monetary policies as stabilisation policies of the government. The expansionary fiscal policy is brought about by the changes in government expenditure and taxes. These changes would affect the aggregate demand , gross domestic product and employment. In expansionary monetary policy, the Federal Reserve Bank (The Fed) changes the required reserve ratio, the discount rate or carries out open market operations. These tools moves the economy out of recession by affecting the money supply, interest rates, spending, aggregate demand, gross domestic product and employment. Introduction: The goal of every economy is to operate at full employment equilibrium. The policy which can do the job of stabilising the equilibrium output to the full employment level is known as stabilisation policy. There are two types of stabilisation policy. They are fiscal policy and monetary policy. Fiscal policy refers to any change in ‘fisc’ which means treasury. In a broad sense the change in fisc is brought about by changes in the revenue -expenditure policy of the Fed. Summary of revenue and expenditure can be represented by the government budget. The budget has two elements : tax revenue (T) constituting the major source of government revenue and government expenditure (G). The monetary policy refers to any change in money supply brought about by the monetary authority. One of the most important way in which the monetary authority can affect the credit market is open market operations (OMO). In OMO the Fed makes sales and purchases of Government securities in open market. Another instrument of the monetary policy is the change in the required reserve ratio. The required reserves are the minimum balance that the Fed requires a bank to hold in the vault cash or on deposit with the Fed. The percentage of such deposits are called the required reserve ratio. The third instrument is the discount rate. Changes in the discount rate occur when The Fed changes the rate of interest on loans (Tucker,2008). Method/Model used : In order to analyse the effects of fiscal and monetary undertaken by The Fed we consider commodity, money and labour markets. The commodity market equilibrium condition is given by Y = C(Y) +I(r) + A+G Where C(Y) is the consumption demand and Y is the disposable income I(r) is the investment demand which depends on the rate of interest(r). A is the autonomous investment expenditure. The money market equilibrium is given by : M = L1(p,y) + L2(r) Where L1 is the transaction demand for money which depends on the money value of the national output(py). L2 is the asset demand for money which depends on the rate of interest(r). The labour market equilibrium condition is given by: W0/p = F´(N)------labour market equation. Y = F(N)------------Aggregate production function Where w0 is the wage rate P the price level N the level of employment. The commodity and money market represent the demand side of the economy whereas the labour market and the production function represents the supply side of the economy. Expansionary Fiscal policy- Rise in government expenditure: Suppose the economy is in a state of unemployment equilibrium due to a deficiency in the aggregate demand for output. Due to this ,suppose The Fed increases its expenditure (G) by borrowing from the public. As a result ‘Y’ will rise via the multiplier effect. In order to finance larger volume of output people will demand more money in the transaction balance. Since the Fed finances the additional expenditure by selling bonds bond prices will fall and rate of interest(r) will rise. The rise in r will release money from asset to transaction balance . But the rise in r will crowd out some private investment but still there will be some increase in the aggregate demand for output. Since aggregate supply of output has not yet changed there will appear excess demand in the output market. As a result price will rise. The rise in price will affect both the demand side and supply side of the economy. On the demand side kpy will rise. In order to get more money in the transaction balance people will sell off some bonds. This will cause bond prices to fall and r to rise. At a higher r less money will be held in the asset balance. The rise in r will crowd some private investment. This is the second round of crowding out. On the supply side of the economy the rise in p will lead to a fall in real wage w0/p which implies that employment will rise which in turn will increase the supply of output. Thus both the demand for and supply of output rises in response to a rise in G. Reverse will be the case for a decrease in the government expenditure.(Branson,1993) Cut in tax rate Now, let us assume the Fed undertakes a tax cut policy. As a result the disposable income will increase which will increase the incentive to work harder and produce more. As a result the firms will invest more which will increase the level of output ‘Y’. Again the firms will also create new ventures which will increase jobs and output. This will cause the aggregate supply to increase. Thus from the supply side it can be said that the economy expands , employment rises and inflation is reduced. But according to Keynesian policy a tax cut increases the disposable income which increases the money for spending. Thus people will try to spend this extra income on more goods and services. This will cause the aggregate demand to rise as a result the economy expands, employment rises and there will be a rise in inflation. (Tucker,2010) Diagramatic exposition Let us consider the following figure : AS P 215 E2 ´ 210 E1 X AD´ AD Y 12 13 (full empl) 15 In the above figure we see that the economy that the economy is in a state of recession at the initial equilibrium level E1. The initial output level is 12 billion real GDP and price level 210. To reach the full employment output level 13 billion the aggregate demand curve will have to be shifted to the right by the horizontal distance E1X i.e. an increase of 3 billion real GDP. This can be done by an increase in government spending. Given a spending multiplier of 3 i.e. a 1 billion increase in government spending will bring about a 3 billion shift of the aggregate demand curve. The equilibrium shifts from E1 to E2 and the real GDP changes by 1 billion. In the same figure we consider a tax cut policy. The initial equilibrium is at point E1. The aim is to shift the aggregate demand curve to the right through point X i.e. an increase of 3 billion real GDP. Let there be cut in tax of 1 billion. As a result disposable income rises by 1 billion. Assuming that the marginal propensity to consume (MPC) is 0.5 the increase in consumption spending will be 0.5*1 billion=500 million. Thus we see that the tax cut causes an increase in output level but this increase is less than the increase in output level due to an increase in government spending. Monetary policy: Another instrument for stabilising the economy and move the economy out of the recession is the expansionary monetary policy. The three tools monetary expansion are open market operations, changes in the required reserve ratio or changes in the discount rate. The first tool that may be used by The Fed may open market operations(OMO). In OMO the Fed makes sales and purchase sales and purchases of government securities in the open market. If the Fed purchases government securities in the open market with the new issue of money there will appear an excess demand for securities. With the increase in money supply money market will be thrown out of equilibrium. Since bond prices are rising rate of interest will fall. At a lower rate of interest people will demand excess money. In this way the money market equilibrium will be restored back but at the lower rate of interest. The fall in the rate of interest will affect the credit market. I(r) will rise as r falls. The rise in investment demand will initially increase the aggregate demand for output (C+I+G). The initial impact of a rise in demand will cause the equilibrium output to rise via the multiplier effect. As a result there appears an excess output demand will cause the price level to rise along with an increase in output. This causes the employment to rise.(Mankiw, 1996) Changes in the required reserve ratio(RRR): As earlier stated the minimum balance a bank is required to hold in vault cash or deposits with the Fed is the required reserves. The percentage of deposits that must be held as required reserves is called the required reserve ratio. Excess reserve exists when the bank has more reserves than required which facilitates the bank to make more money by giving loans against deposits. This increases the money supply in the economy. If the objective is to decrease the money supply excess reserves are reduced i.e there is an increase in the reserve ratio . Thus in order to combat a recession the money supply should be increased which means the required reserve ratio must be decreased. The money multiplier is used to calculate the change in money supply due to a change in excess reserves. Money multiplier=1/RRR Actual change is Money multiplier * initial change in excess reserves =money supply change. When money supply is increased due to a decrease in the reserve ratio there will appear excess supply of money as a result the money market will be thrown out of equilibrium. The equilibrium will be restored back by a reduction in the rate of interest . The fall in the rate of interest will increase the investment demand which will result in excess demand . As a result price level will rise along with the increase in output and employment. Changes in the discount rate : The change in the discount rate occur when The Fed alters the interest rate on the loans of the reserves to bank. When the Fed lowers the rate of interest it becomes easier for the banks to borrow reserves from the Fed. This expands the supply of money. Reverse is the case when the discount rate is increased. It discourages the banks to borrow reserves from the Fed which in turn contracts the supply money. Therefore to draw the economy out of the recession there should be expansionary money supply which can be done by reducing the discount rate. Thus by lowering the discount rate The Fed increases money supply . Lag in monetary policy versus fiscal policy There are two basic problems in the exactment and implementation of fiscal and monetary policy .the most important is the presence of lags .There are two types of lags. They are inside lag and outside lag. The inside lag refers to the passage of time that elapses between an economic disturbance and the implementation of the policies to correct the disturbance. The inside lag is fairly short because The Fed has financial data on a daily basis , inflation and unemployment data on a monthly basis and real GDP in every three months. This enables the Fed to decide quickly the policy options. The inside lag for the monetary policy is shorter than fiscal policy. The outside lag refers to the passage of time that elapses between the implementation of a policy and the actual effects of the policy on aggregate demand, employment, price level and real GDP. The total lag for monetary policy can be 3 to 12 months but for fiscal policy it is not less than a year.(Tucker, 2010, p.681) Concluding Remarks Thus from the above discussion we see that in order to bring the economy out of the recession The Fed undertakes either expansionary fiscal or monetary policy. The tools of expansionary fiscal policy are increase in government expenditure or a cut in tax rate. This will cause the aggregate demand to rise which will cause the increase in the level of employment and price level. The tools of expansionary monetary policy are OMO, required reserve ratio and the discount rate. We see that either purchase of government securities, decrease in the required reserve ratio or the decrease in the discount rate will have an expansionary effect on money supply . This will have a positive impact on real GDP, employment and the price level. REFERENCES Branson, W.H. (1993), Macroeconomic Theory and Policy, A.I.T.B.S Publishers and Distributors Mankiw, G. N. (1996), Macroeconomics, Worth Publishers Tucker, B.I.(2010). Economics of Today. USA; South Western Cengage Learning Tucker, B.I.(2008). Macroeconomics of Today. USA; South Western Cengage Learning Tucker, B.I.(2010). Survey of Economics.USA;South Western Cengage Learning Read More