Economic Situation In Slovenia Post Financial Crisis - Research Paper Example

ECONOMIC SITUATION IN SLOVENIA POST FINANCIAL CRISIS Executive Summary Slovenia, a member of OECD experienced a serious decline in its economic growth and unemployment followed by fiscal austerity programs undertaken by its government to recover from the crisis of 2008. Such steps were taken in view of the outstanding debt burden, excessive credit growth and low risk assessment in the economy. This paper highlights the effects of fiscal austerity measures on the Slovenia economy in the context of macroeconomic models of Keynesian Cross and AD-AS and IS LM framework. The estimation of multiplier effect provides the cause of such economic slowdown (fall in output, employment and growth) in Slovenia after the fiscal policies involving a cut in government expenditure and rise in the tax rates was initiated. The paper ends with a conclusion about the major impacts of such financial consolidation in the economic condition of Slovenia and provides a short recommendation to the future policy makers. Table of Contents Table of Contents 3 1.0 Introduction 4 2.0 Models of Economic Equilibrium 4 2.1 Keynesian Cross 4 2.2 IS-LM model 7 2.3 AD-AS model 9 3.0 Multiplier Effect and Automatic Stabilizers with reference to Keynesian Cross 11 5.0 Effects of Austerity Programmes on Public Debt, Economic Growth and Unemployment 15 6.0 Recommendation and Conclusion 21 Reference List 23 1.0 Introduction Slovenia is a developed state in the central Europe which experienced a period of boom between the years 2004 to 2006, when the economy grew at a rate of 5 % per annum. The economic growth surge was mainly due to the rising expenditure (mainly in construction) supported by public debt (OECD, 2015). However, after the global recession of 2007, Slovenia entered in a period of financial austerity to reduce its burden of debt which was earlier created by bailing out its banks. Slovenia’s austerity programmes were aimed at reducing its budget deficit caused by the amounted debt. The austerity policies of the government hence included the rise in the tax rates or introduction of new taxes, reduction of public expenditure and privatisation of state owned companies (Nova Kreditna Banka Maribor; communications operator Telekom Slovenija; airline Adria Airways; Ljubljana airport and Elan ski manufacturer). Such kind of financial strictness often results in rising unemployment; fall in consumption level and higher debt to GDP ratio (despite being fall in the budget deficits). With advent of rising debt obligations of Slovenia, financial austerity is a well justified approach by the government. The easier accessibility to credit and the meagre risk assessment prior to the crisis had resulted in such unsustainable debt (OECD, 2015). The economic reforms in the form of financial consolidation, privatisation and recapitalization of banks were hence required to drive the credibility of the country in financial market and spur the economic growth. 2.0 Models of Economic Equilibrium 2.1 Keynesian Cross The Keynesian Cross illustrates the aggregate demand and supply relationship in determining the equilibrium level of national income (Macrobasics, 2015). The consumer spending is a rising function of the consumer’s disposable income and in the Keynesian cross diagram, the level of equilibrium output is determined at the point where the total expenditure and supply of the economy intersects this curve of consumer spending. The intersection point hence establishes the equilibrium output Y of the economy. Figure 1: Keynesian Cross (Source: Macrobasics, 2015) The 45° line represents the points where the aggregate expenditure equals the aggregate production in the economy; while, the blue line represents the aggregate demand of the economy. The intersection point is the level of equilibrium output of the economy. The Keynesian cross equation is given as:  YAD Y= Aggregate output supplied YAD= Aggregate Demand C= Consumption;  I= Investment G= Government Expenditure NX= Net Exports. The equation states that AD will rise with the increase in any of its component and hence, there will be excess demand in the economy as supply remains unchanged. Thus, the producers will increase their production and supply to meet the rising demand which will raise the aggregate supply and this process continues till the aggregate output reaches the AD and the equilibrium is achieved. The opposite situation happens when aggregate demand falls and excess supply prevails in the economy. The diagram illustrates well how the equilibrium is reached by the mechanism of demand and supply in the economy. Figure 2: Mechanisms of Equilibrium in Keynesian Cross (Source: Macrobasics, 2015) 2.2 IS-LM model The IS-LM model evaluates the relationship between interest and real GDP in the economy both in the product market and the capital market. Under the IS-LM framework, general equilibrium is achieved by the intersection of IS and LM curves when equilibrium simultaneously prevails in both the markets. The IS (Investment and Savings) equation which shows the equilibrium in the product market is given by: where Y= real GDP or National Income = Consumption, a function of disposable income I(r) = Investment, a function of real interest G = Government expenditure NX (Y) = Net exports, function of Y LM (Liquidity preference and Money supply) equation which represents the equilibrium in money market is shown by: where m = real money supply ( actual money supply M divided by price level P ) L(i,Y) = demand for money which is a function of interest rate (i) and income (Y) The determination of equilibrium by intersection of the IS and LM curves are shown in the figure below: Figure 3: Equilibrium of IS-LM model (Source: Policonomics, 2015 ) The IS curve is a downward sloping curve representing the negative relation between the income and interest rate in the product market. It indicates that the income falls with the rise in the interest rate and vice versa. A higher interest rate will induce the people to save more (as they will get higher return) which leads to fall in consumption and hence, in real GDP. On the other hand, LM curve evaluates the equilibrium in the context of money market and the curve is upward sloping, i.e. rise in the interest will result in increase in the income and vice-versa. This is because of the fact that with rise in interest, people demand less money. On the other way, as income increases, people tend to spend more and hence, demand for money increases keeping L constant and thereby, maintaining equilibrium in the money market. 2.3 AD-AS model The equilibrium price level and output in economy is determined through the interaction between aggregate demand and aggregate supply in the AD-AS model. The given figure explains that the price level and output reaches equilibrium when the AS and AD intersects each other. Figure 3: AD-AS Model (Source: ) The equation of AD curve is given by:  Yd  Y= real GDP, M= real money supply, G= Government Expenditure, T=Taxes, Z1= other exogenous variables that can affect the consumption. The equation of AS curve is:  Ys  Y= real GDP, W/P= real wage rate, P/Pe= is general price level with respect to the expected price level, Z2= other exogenous variables influencing the labour demand. Any movement or shift in the AD curve caused by exogenous factors will result in fall or rise in the income and price level of the economy. For example, decrease in the taxes will result in rise in the disposable income simultaneously raising the level of consumption. This causes an upward shift of the AD curve (from AD1 to AD2) while supply curve unchanged and thus, the new equilibrium is achieved at the intersection of AD2 and AS where the national income and price level rises from earlier situation. 3.0 Multiplier Effect and Automatic Stabilizers with reference to Keynesian Cross The change in equilibrium Y due to one unit change in any autonomous aggregate expenditure is defined as the Keynesian multiplier. Given the equilibrium equation of Keynesian cross, the Keynesian multiplier is derived in the following way:  =  ; Differentiating the above equation with respect to G (other parameters remaining constant) Cy Ty  or,  or,  = > 1 This represents the change in Y due to one unit change in G. So, if G rises by amount then Y rises by  Y =  The multiplier effect explains well the automatic mechanism of equilibrium output in the economy. As the autonomous or government expenditure increases by one unit, then under the effective demand principal equilibrium Y increases initially by one unit. This rise in Y further leads to increase in the disposable income (but not by the same amount due to the taxes). Accordingly, consumption rises for which Y increases again in the successive round. This process continues till a new equilibrium is achieved (Smith, 2013). This kind of similar mechanism is observed in case of rise in the tax rate. The change in equilibrium Y due to change in one unit of tax rate is called as tax rate multiplier of Keynesian cross. At equilibrium,  =  ; The change in Y with respect to change in one unit of tax rate is given by = Cy [ or, Cy (Cy or,   < 0 In contrast to the Keynesian multiplier, the tax rate multiplier is negative as the rise in tax rate will lead to fall in consumption and aggregate demand in the economy and vice-versa (Otaki, 2007). 4.0 Evaluation of Multiplier Effect in the Product and the Financial markets From the IS-LM framework it has been derived earlier that, At product market equilibrium,  At money market equilibrium,  The effect of various fiscal measures (government expenditure and taxes) on the product market and financial market equilibrium is evaluated through mathematical equations in the following section. A. Effects of a change in the autonomous expenditure (G) on equilibrium Y and r at constant P Initially equilibrium Y and i are Yo and io respectively determined from the intersection between IS and LM curve. The effect of Y due to change in one unit of G is therefore shown by: Cy  Ty+ Ii  or, Cy ( 1- Ty)]  - Ii  = 1 and, Ky  + li = 0 By using Cramer’s rule,   = > 1 The above equation represents IS LM multiplier effect of aggregate spending (G) which is greater than 1. This means that with one unit rise in government expenditure, equilibrium (Y) will increase more than one. Thus, IS LM multiplier stimulates the level of output or aggregate demand in the economy due to its cumulative effect. B. Effects of a change in the Taxes (T) on equilibrium Y and r at constant P Initially, equilibrium Y and i are Yo and io respectively determined from the intersection between IS and LM curve. The effect of Y due to change in one unit of G is therefore given by; Cy  Ty+ Ii  or, Cy ( 1- Ty)]  - Ii  = -Cy.Y and, Ky  + li = 0 By using Cramer’s rule,  Cy.Y  =Cy.Y  < 0 In contrast to ISLM multiplier, the tax rate multiplier is negative which means the one unit rise rate will result in decrease in the national income (Fanti and Manfredi, 2007). 5.0 Effects of Austerity Programmes on Public Debt, Economic Growth and Unemployment Post economic crisis of 2007, as Slovenia economy struggled hard to recover from economic downturn, the government implemented number of reforms including financial consolidation to raise the credibility of the economy in the capital market. The reforms included cut in government expenditures, rise in the level of taxes along with introduction of new taxes and large scale privatization of the public sector units. Although such reforms were believed to reduce the public debt which rose significantly from 22% of GDP in 2008 to nearly 80% in 2014 (OECD, 2015), it had huge negative impact on the economy in the form of rising unemployment, fall in consumption and aggregate demand and subsequent low level of output. As government spending is a major component of GDP, the reduction in government spending will result in fall in GDP and higher debt output ratio (Ramey, 2011). The effect of reform or financial consolidation can be explained in terms of macroeconomic theories of general equilibrium explained before. The decision of the Slovenia government to reduce the level of expenditure will result in fall in total output and employment (by the Keynesian multiplier effect). The mechanism is shown in the diagram given below: Figure 4: Effect of reduction in Government expenditure on the national output When the government expenditure falls, the multiplier effect of the Keynesian cross can be applied. As G is a contributor to aggregate demand in the economy, the reduction in G will result in decrease in demand causing a downward shift of the AD curve ( from AD1 to AD2). The fall in demand is mainly due to decrease in government expenditure mainly in the construction and manufacturing activities and other infrastructural projects. This will result in the loss of jobs of those engaged in these activities and hence, the rate of unemployment will therefore increase in the economy in the short run. The rising unemployment will further have repercussion effect on the demand of the economy as people without jobs tend to reduce their level consumption. The rising rate of taxes or the new taxes will also simultaneously affect the aggregate demand of the economy in a similar way as the disposable income of the consumers fall because of the higher taxes (Sen, 2005). The consumer hence reduces their level of spending and thus, the demand for goods and services in the economy fall significantly. In Slovenia, fall in government expenditure has resulted in such outcomes leading to further slump in the output and growth rate. The IS-LM model and the multiplier effect can explain the effects of financial consolidation in the short and long run. In the short run, when prices are given, the fall in the expenditure of the government results in decrease in Y which causes the IS curve to shift downward (from IS1 to IS2) and LM curve remaining same as before the equilibrium Y falls (Y1 to Y2). This happened in case of Slovenia economy as the fall in G was experienced with diminishing level of output (Y) in the economy. Figure 5: Shift in IS curve and effect on Y This consequently gave rise to the rates of unemployment as the jobs disappeared due to the cut in government spending and the loss in jobs meant further fall in consumption level in the economy leading to in fall in AD and hence, income Y. Thus, the economy was likely to suffer from the vicious cycle of lower economic growth in the long run due to slump in economic activities caused by falling expenses by the Government. Figure 5: Fall in employment in Slovenia pre and post crisis (Source: OECD, 2015 ) The effect of rise in taxes by the government as a part of reforms of financial consolidation programmes also lowered the equilibrium level of output (Y) in the country in short run as the disposable income with the consumers declined significantly which reduced the demand for goods and services. This explanation can be based on the above expression of IS-LM tax multiplier which shows the multitude effect of tax rate on the national income as the value of multiplier is greater than one. This clearly indicated that the financial strictness by the government which was also accompanied by rising rate of taxes resulted in excessive fall in the level of national income. Thus, Slovenia economy experienced a serious setback followed by 2009 crisis when GDP shrunk to a lowest rate. As the economy started to recover slowly from the recession, it again slid into economic slump in the last quarter in 2011 which has been due to falling domestic consumption and sharp decline in the exports. Before the crisis, Slovenia had been financially strong with minimal budget deficits and public debt was merely 22% of GDP (OECD, 2015). It was believed that the crisis exaggerated the economic situation to a large extent because of irresponsive fiscal policies, state ownership of important banks and the lack of reliability on the Euro area (Greene, 2013) In the face of the financial crisis, the government adopted the financial austerity measures abandoning its conservative policies. 6.0 Recommendation and Conclusion Slovenia was stuck in the situation of economic slowdown post financial crisis of 2008 when the government took a well planned step towards financial consolidation to recover from the economic slump. However, the impacts of such policies have repercussion effects on the major macroeconomic indicators of the country like growth rate, unemployment and the level of consumption and investment. The Keynesian multiplier and the IS LM multiplier illustrates well the causes of such fall in income and employment. The outstanding level of public debt in the economy induced the government to undertake such measures. The weak framework and supervision of the banks resulted in misallocation of capital and poor standards of credit. The reforms implemented in response to the financial crisis, although raised the economic feasibility in financial market by effective recapitalization of the banks, but the banks were still exposed to profitability and credit risk due to relatively high ratio of nonperforming assets. There was a need for strengthening and restructuring the banking sector in the economy along with stabilization of public debt. The government should adopt a proper fiscal rule having transparency and an effective council should be instituted which will assess the adherence of the fiscal rule. Apart from these, the rising rate of unemployment in the economy owing to decline in economic activities requires much attention. Labour market reforms in the form of wage policies and individual programs for recognizing the low skilled and long term unemployed will help in creating jobs and improving labour productivity. Thus, Slovenia in order to regain financial sustainability and reduce its debt obligations entered into financial austerity which eventually resulted in further slump in the economy. Hence, there is a need for devising the austerity programs in such a way which would instead stimulate the expenditure and enhance the economic growth. Reference List Fanti, L. and Manfredi, P., 2007. Chaotic business cycles and fiscal policy: an IS-LM model with distributed tax collection lags. Chaos, Solitons & Fractals, 32(2), pp.736-744. Greene, M., 2013. An Austerity Success Story in Slovenia. [Online] Available at: [Accessed 10 November 2015] Macrobasics, 2015. Basics of macro economics. [Online] Available at: [Accessed 10 November 2015] OECD, 2015. OECD Economic Surveys Slovenia. [Online] Available at: [Accessed 10 November 2015] Otaki, M., 2007. The dynamically extended Keynesian cross and the welfare-improving fiscal policy. Economics Letters, 96(1), pp.23-29. Policonomics, 2015. IS-LM. [Online] Available at: [Accessed 10 November 2015] Ramey, V. A., 2011. Can government purchases stimulate the economy?.Journal of Economic Literature, 49(3), pp.673-685. Sen, P., 2005. Perfect Competition and the Keynesian Cross: Revisiting Tobin. [Online] Available at: [Accessed 10 November 2015] Smith, N., 2013. Calling the Keynesians’ Bluff. [Online] Available at: [Accessed 10 November 2015] Read More