The Recovery from the 2008-9 Recessions and the Shape of the Aggregate Demand and Supply Curves - Coursework Example

MACROECONOMICS Describe the recovery from the 2008-9 recessions, and identify the differences between the Euro area, the UK and the USA. The Euro area, UK and USA went into recession in 2008 and world growth overall has overall slowed. In the Euro area and UK, the fiscal policy is contractionary and the monetary policy is expansionary, but in the US, the fiscal and monetary policies are expansionary. The Euro area is also facing a downward trend in their GDP, deficits and borrowing costs are rising, making the growth market negative. (ONS, 2012) Growth in UK and USA was also misleading due to the fact that there was a great deal of borrowing, particularly by the public sector. Falling unemployment leads to a decrease in recession, this was more pronounced in USA and UK than Euro area. And this growth, lower inflation rate and employment lead to a period called “moderation” and lead to betterment of the economies. (England, 2012) Euro Area experienced the greatest recession in 2009 and a drop in GDP by about 3%. By the end of 2009, the GDP situation had improved and since then Euro Area has experienced a positive growth rate about 0% except for 2012 which again shows the Euro Area going into a recession by about 0.2 %. UK faced the recession at an earlier duration but by a lesser degree, with the GDP growth rate falling by about 2%. The situation improved, with a 1% GDP increase in 2010 and since then the GDP has been fluctuating below 1% ad above 0% GDP increase. The GDP drop was also not as sharp as Euro Area’s but over duration of 2008. USA experienced recession at about the same time but it was a much sharper drop and lead to an increase of about 1% percentage points and its GDP has been fluctuating since then, however, there has been GDP growth, even if it is minimal. 2. Explain the shape of the aggregate demand curve. The aggregate demand curve shows the inverse relationship between the price level and the level of real GDP. That is, the lower the price level, the higher is the level of GDP and vice versa. There are several reasons for the downward sloping shape of the AD curve: Real Balances Effect Price levels also affect the consumption patterns of consumers. If prices are lower, making the money that they hold more valuable, they are likely to purchase and consume more. These goods could also be financial assets and they are also affected by the inverse relationship between price level and real level of GDP. Interest Rate Effect The interest rate has a direct relationship with the price level and their relationship also affects the shape of the AD curve. This is because an increased price level increases the cost of borrowing and consequently interest rates increase as the demand for borrowed money increases and this leads to a investment and consumption and lower aggregate demand. Net Exports Effect As price level in one economy falls, the prices of the goods and services in that economy fall and consequently foreigners purchase more of that economy’s goods and services, which leads to that economy exporting more, resulting in an increase in the aggregate demand. Individual factors also cause a change in the shape of the AD curve, such as consumption patterns, government expenditure in the economy and the pattern of investment in the public and private sector. (Economist, 2012) Any factor that effects the consumption, investment, government spending, and net exports of the economy, can shift the AD curve outward or inward. Investment may be affected by interest rates. (Government, 2011) 3. Explain the shape of the aggregate supply curve. The aggregate supply curve shows the different amounts of goods and services produced at different price levels. Keynesians believe that aggregate supply curve is horizontal so an increase in government spending and aggregate demand results in an increase in the production of goods and services but the price level remains the same. However, classical economists believe that price level and production of goods and services keep changing in accordance with market needs in order to keep the economy at full employment level. The AS supply curve is positively sloping since it is determined by price level. An increase in price level will lead to more output since the prices of goods and services will increase. It will also lead to an eventual increase in the price of inputs and therefore there will be a cutback in the output of products and services as well. This is why there are short term and long term supply curves unlike the demand curves. It is unsure whether an increase in price level will lead to an increase in the output or GDP of an economy due to the aforementioned reason. (Economist, 2012) 4. Explain equilibrium in the aggregate demand and aggregate supply model. Macroeconomic equilibrium is the term used for the point where the aggregate demand and supply curves intersect. These are assumed to be short term curves rather than long term ones and all economies strive to be at this point. If the price level in the economy is above this point, there will be an excess of supply for goods and services and not enough demands, and if the price level is below this point, there will be an excess of demand for products and services and not enough supply. At this point, the products and services produced are just enough to meet the demands of the population. However, in either of these cases, the market forces will always bring the economy back to equilibrium. If the prices are high and there is excess stock, the market forces will signal the market to lower prices and this will increase the demand, thereby bringing the market back to normal and to the equilibrium position. Similar changes can occur with the movements of the AS and AD curves both. (IMF, 2012) 5. What is fiscal policy and how is it used to affect economic activity? Fiscal policy traditionally has two components: aggregate government spending also called expenditure, and revenue, also called tax collection. These activities affect the aggregate demand and supply curves. Government spending and tax revenue are seen to have affects on the aggregate demand especially in the UK where the government spending in health and education gave the economy a fiscal boost and shifted the AD curve outwards. However this effect is expected to be temporary. They also plan on cutting down taxes in order to stimulate consumer demand. (Exchange, 2011) Aggregate supply is also affected by fiscal policies in almost the same manner, however, the effect is presumed to be more long term than the effects on aggregate demand. (Exchange, 2012) Overall, the government spending will increase and tax revenues will decrease if the economy is in recession and vice versa in an expansion. Also, during recession, labor and resources etc. are cheaper and so governments should encourage investment in infrastructure so in order to take advantage of the recession. Lastly, the government is advised not to resort to too much borrowing as this might discourage the private economy since they do most of the lending to the government. Discretionary fiscal policies can boost the economy and especially expansionary policies. (Wolf, 2011) Fiscal policies are aimed at boosting confidence in the economy and bring debt and deficits on the right track. A fiscal stimulus would lead to a multiplier effect that is the change in income related to change in spending, be it by the consumer or the government. In USA as well, the increase in government spending was seen to have a multiplier effect. Similar was the case in UK. The government was trying to increase aggregate demand by injecting more money in the economy. 6. The Euro area and the UK are trying to reduce the government deficit by increasing taxes and reducing government expenditure. Explain the effect this may have on the economy. The Euro area and UK are trying to reduce fiscal deficits by increasing taxes and reducing government expenditure. This will stabilize the economy in terms of aggregate demand and overall growth. The US government actually invested 15 million dollars in the economy. These measures are essential because of the high level of deficit and the increasing government debt that these economies face. Defici reduction would mean tat markets would retain their confidence in the UK government debt and it would also keep interest rates low, such as in UK they came down from 17.5 to 15%. If the government demand decreases as well, this is offset by the private demand and the economy would not go into a recession. Consumption, investment and exports are all constrained currently, and the economies are under the threat of going into a recession again. All these measures are taken to ensure that the government can pay current and later debts. However, the market is much more complicated and fiscal policy can actually prove to be detrimental, as economies tighten their fiscal policies. So as the governments actually try to better the economy and gain from tightening, the growth of the economy is actually lower, and so the gains of the fiscal policy are lost in the low growth of the economy. (England, 2012) Tightening fiscal policy, i.e. increasing taxes and reducing government expenditure will reduce aggregate demand and tend to reduce economic growth. The government argues that this is essential because of the very high level of the deficit and the increasing level of government debt. The government argues that deficit reduction means the markets will retain their confidence in UK government debt and keep interest rates low. The economy will not go into recession because private sector demand will offset decreased government demand in the economy. 7. Why are governments finding it difficult to reduce their deficits? There are many reasons why governments cannot reduce their deficits. The biggest reason is that the recession makes it difficult as this leads to increases in government expenditure and reductions in tax revenue. Unemployment increases during recessions and so this leads to more government expenditure on social security benefits. This is a major problem in the Euro area as their deficit is high. Interest rates also rise during a recession and so the cost of borrowing increases, thus making demand lower and so revenue lower and this further makes it difficult to lower the deficits. (Buiter, 2010) It is difficult to increase exports because the products are not competitive enough on the foreign market. The lack of competitiveness coupled with recession makes it difficult for the deficit to be lowered even further. This is because growth is also slow, deficits are also high and government debt is also high. (IMF, 2012) 8. Why is conventional monetary policy not very effective in increasing demand in the macro economy at present? The interest rates in all the three economies are low, very near to zero, and therefore the conventional monetary policy is not effective. Monetary policy affects the economy by changing the interest rates and the money supply and if interest rates are already near zero and monetary policy is very loose then the traditional monetary policy cannot do much. One of the focuses is now on inflation rates as well, because the real value of money is taken into account everywhere. Recession has also rendered the monetary policy ineffective. Nominal interest rates cannot be negative; the monetary policy cannot help boost the economy by traditional means. Consumers are trying to reduce their borrowing because they are facing a heavy burden of debt and business do not want to borrow and invest because of the uncertain economic situation. And banks do not want to lend because they are worried about the security of loans and are trying to restore their balance sheets. (Economist, 2012) 9. Explain quantitative easing and how it may affect the economy. Quantitative easing can boost the economy by: Lowering the long term interest rate of the economy Raising the money supply These two policies aim to increase borrowing and lending by the private sector which were previously restricted by injecting money into the economy. Quantitative easing is an unconventional monetary policy by which an economy is stimulated by the central bank when they borrow government securities which are long term in nature. They purchase debt securities also called gilt securities. They then inject a certain pre determined amount into the economy. This is different from the traditional monetary policy of buying and selling government bonds. USA and UK also find it easier to help in government deficits by means of QE as they have the effect of lowering borrowing rates and also making this process more convenient. These policies have managed to increase GDP and inflation rate both in UK and USA. (Wolf, 2011) 10. Assess the use of supply side policies to deal with our current macroeconomic problems. The supply side monetary policies, aimed at increasing productivity and efficiency of the economy have been effective in UK and USA but Euro zone still seems to be in a deficit that will take a while to recover from. However, asset prices can increase even further, and reduce demand, therefore proving the policy worthless. Gilt securities points also fell. Also it is very difficult to separate the QE effects from the confidence of the people in investments. QE can prove to be a double edged sword if not administered properly in its adjustment phase. Lastly, these policies are for a long term solution and the problem at hand is related to demand in the short run. (Joyce, 2011) Bibliography Buiter, W., 2010. The limits to fiscal stimulus. Oxford Review of Economic Policy, 26(1), pp. 48-70. Economist, 2012. Free exchange: The hangoveR. The Economist, p. 75. Economist, T., 2012. 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