The Global Financial Crisis and Fiscal Policy - Assignment Example

Full topic and Section # of Changes in Government Spending – Fiscal Policy The difference between the equilibrium real GDP ($8000) and the full employment level GDP ($10,000) is of $2000. Therefore, the equilibrium level GDP needs to increase by $2000. The formula for the multiplier is: Multiplier = 1/ (1-MPC) = 1/ (1-0.2) (Given that MPC = 0.2) = 5 Since the multiplier is 5, the government spending can be determined by dividing the difference in the equilibrium and full employment level of real GDP by 5: Government Spending = $2000/5 = $400 Thus, through the above calculations, we can derive that the change in government spending that is needed is to increase the fiscal purchases by $400. This will cause the aggregate demand line to shift upward and thus reach the full employment GDP level. By increasing government spending, Mr. President can put the unemployed people back to work and the employment level rises. Also the increase in government spending will result in decreasing desired national savings as the demand for goods is increases. 2. Changes in Tax – Fiscal Policy In order to solve the situation through the tax change instead, we need to determine this with the help of tax multiplier   Change in real GDP = [(change in taxes) * -MPC] / (1 - MPC) Therefore, Change in taxes = Change in real GDP * 1-MPC/ -MPC = $2000 * 0.2 / -0.8 = - $500 From the above calculation, we can say that the President should provide a tax cut/reduction of $500 in order to increase the real GDP to $10,000. A decrease in the taxes will increase the disposable income of the consumers and thus the consumers will consume some part and also save some part of it. 3. Balanced Budget Amendment In this case, since the government spending and taxes are increasing and decreasing with the same amount, the increase in government spending is expansionary however the increase in taxes is contractionary and vice versa. Also, government spending and taxes when increased (or decreased) with the same amount, are impacting the fiscal policy in opposite directions. The government spending impacts real GDP directly by decreasing savings however; the taxes impact real GDP indirectly. For a balanced budget amendment, the multiplier should be equal to one as the increase in government spending should be same to the increase in tax and vice versa. Thus, adding the two multipliers that we calculated above will give us: Multiplier = Change in real GDP + Change in real GDP Change in Government Spending Change in Taxes = 1/1-MPC + -MPC/1-MPC = 1-MPC/1-MPC = 1 This shows that if we increase or decrease the government spending and taxes, the change in real GDP will be equivalent to that. Therefore, in order to increase the real GDP by $2000, we will need to increase the government spending and taxes by $2000 as well. The net increase is however due to the increase in government spending as it effects the real GDP directly. Consequences of the law: Now the question is that due to this balanced budget amendment, would fiscal policy be weakened, or even rendered useless? In order to answer this question, we can see that the classical model and Keynesians have different approaches to it. In balanced budget multiplier, due to the equal increase in government spending and taxes, the recessionary gap can be eliminated without an in increase in the budget deficit as the taxes are also increased which covers the government expenditures that are made to increase the GDP. Thus the positive side is that budget deficit doesn’t increase. On the other hand, if the balanced budget amendment is followed, this practice will weaken the role that taxes play in the fiscal policy as being automatic stabilizers. Also, the increase in taxes will be equivalent to putting a burden on the tax payers which is not healthy for a nation. But the advantage of increasing real GDP without an increase in the budget deficit is the factor that attracts governments to go for a balanced budget approach which will weaken the fiscal policy in the long run. 4. Countercyclical Fiscal Policy: A countercyclical fiscal policy is a fiscal policy that brings the economy to equilibrium by lowering economic activity in a booming period and increasing economic activity in a recessionary period. The Keynesians point of view in this respect is to follow automatic and discretionary countercyclical fiscal policy which decreases the impact of the business cycle. However the classical model suggests that these countercyclical policies can be bad for the economy and result in destabilizing it. The classical model suggests a laissez-faire fiscal policy instead of countercyclical fiscal policy (Robert, 2007). The increase in the budget deficits makes it difficult to use a countercyclical fiscal policy in recent times. This is because as the countercyclical policies lead to larger budget deficits, these are a huge liability and an increasing debt burden in the long run on the country. The increase in the budget deficits also cause crowding out of private investment which is another reason why countercyclical fiscal policy is now difficult to be implemented. These are the cases that justify the use of a cyclical instead of a countercyclical fiscal policy in recent times. However, there is a need for countercyclical fiscal policy in order to avoid demand shocks. If the country has enough fiscal reserves and structural surplus position, countercyclical policy is effective to be used. We have seen that most of the Asian developing countries have been using the countercyclical fiscal policy and it has been working effectively for them. The research also suggests that the tax cuts (if used effectively and efficiently), are more effective in the countercyclical policy than the government spending (Shikha, 2010). However, tax cuts effect indirectly and are less flexible as compared to changes in government spending. 5. Should the Federal Budget be Balanced Annually? So far, we’ve seen the advantages and disadvantages of following a balanced budget. But, we need to know does it actually work in the real scenario? Should the federal budget be balanced annually? Common sense says yes; as this seems to be an unbiased kind of a policy. The amount that the tax payers pay is the same as the amount that the government spends and rationally this seems just fine. But when countries are already experiencing budget deficits, this balanced budget is although not increasing the budget deficit but most importantly it is not even decreasing the budget deficits (John, 2009). This policy will work fine at full employment level when everything is working fine; but what about the recessions and inflationary periods? In a recession, a balanced budget will increase the taxes and increase the government spending with the same amount which will result in a budget deficit in the long run. In recessions, there is a need to increase the total spending by cutting taxes and increasing taxes certainly do not lead to increasing total spending. Similarly, in a period of inflation, the balanced budget will call for decreasing the government spending and decreasing taxes as well. A decrease in taxes will cause an increase in the consumption and put rather more pressure to the inflation rather than normalizing it. With a balanced budget, it is very difficult for an economy to reach back to its full employment levels as it puts more pressures on recession as well as in inflation and in order to adjust the equilibrium levels, the countercyclical policies become essentially important (Richard, 2002). Just because it seems rational for individuals to balance their budgets doesn’t mean the economy will also work just fine that way. The increasing budget deficits are a huge problem which is the reason we cannot follow a balanced budget and ‘maintain’ budget deficits but rather there is a strong need to reduce them through expansionary and contractionary fiscal policies. References Alesina, A. and S. Ardagna (2009) Large Changes in Fiscal Policy: Taxes versus Spending. NBER Working Paper 15438, National Bureau of Economic Research, Cambridge. Auerbach, A (2002) Is there a role for discretionary fiscal policy? Rethinking stabilization policy, Federal Reserve Bank of Kansas City. Bent H. (2008) The Economic Theory of Fiscal Policy. Volume 3. Routledge Library. Taylor and Francis. Cogan, J. F., T. Cwik, J. B. Taylor, and V. Wieland. (2010) New Keynesian versus Old Keynesian Government Spending Multipliers. Journal of Economic Dynamics and Control 34(3):281–95. John W. (2009) The Global Financial Crisis and Countercyclical Fiscal Policy. Centre for Development Policy and Research. University of London. Available from Richard H., Kell M. and Selma M. (2002) The Effectiveness of Fiscal Policy in Stimulating Economic Activity—A Review of the Literature. IMF Working Paper 02/208. Washington: International Monetary Fund. Robert E. Hall and Marc Lieberman (2007). Macroeconomics: Principles and Applications. 4th Edition. Cengage Learning. Shikha J., Sushanta M., Donghyun P., and Pilipinas Q. (2010) Effectiveness of Countercyclical Fiscal Policy: Time-Series Evidence from Developing Asia. ADB Economics Working Paper Series No. 211. Available from Read More