Micro Foundation in Finance - Example

Micro Foundation in Finance Micro Foundation in Finance Introduction The researcher seeks to investigate the economic status of this economy in order to help the Chancellor of the Exchequer in designing a budget that incorporates the provisions of the Prime Minister’s letter. The Prime Minister is disturbed by the need for a satisfactory budget as this will determine the shape of the next general election. The paper will determine the correct position of both output and demand and to showcase such conditions to levels of unemployment and labour supply. In addition, the researcher will ensure that the attainment of full employment does not culminate into a balance of payment deficit based on the choice between increasing government expenditure and reducing taxations. The paper also examines the effectiveness of National Institute’s forecast of unemployment on the basis of unchanged government policies in order to determine its feasibility to ensure adoption of a policy leading to full employment. The analysis of the consumers ’expenditure expectation reveals a projection of the annual rate of £1 million plus 3/4 of personal disposable income. Based on the investment component, it seems that firms are entering their final phase of investment programme. Following this, the investment is projected to be lower than that in the past. In addition, the investment is unlikely to be at all sensitive to current levels of output. On the other hand, the projected level of gross domestic fixed capital formation is £4 million. Government intervention in the economy is limited to direct expenditure on goods and services as well as raising of revenue through the taxation of incomes. Besides, the existing government programmes are likely to lead to expenditure on goods and services of £4 million. The current levels of taxation are likely to yield to the government, a sum equal to 20% of national income. Examination of productivity reveals a little increase since last year hence should the economy attain a position of full employment, its gross domestic product would be £20 million. Evaluating the international situation showcased that the recent international monetary crisis has somewhat checked the growth of world trade. Therefore, the exports are unlikely to exceed £2 million while the imports would represent about 20% of gross domestic product. The paper uses the Keynesian, neoclassical and classical assumption will be critical to this discussion to uncover and solve the Prime Minister’s concerns. Body Budget deficits refers to the yearly excess of government expenditures over revenues while the government debts refers to the deficits accumulated over the years have soared in various industrial countries over the years and such countries are disturbed by a challenge of bringing them back to the earth (Shaviro, 1997). The growth of government spending exceeding the growth of goods and services leaving the revenue to trail far behind accounts for the increased budget deficit in many nations. On the hand, the average growth of tax revenue to Gross Domestic Products in industrial countries have more than doubled over the years, the corresponding ratio for government expenditures has also grown above that of taxes which is estimated to be an equivalent of half the value of all goods and services produced over the years. With the high levels to which the taxes have grown and the threat of stifling growth via raising taxes further, holding the political consequence of thriving to influence it, it is justifiable to suppose that reducing government spending avails the bests framework, if not only mechanism, of weeding out these fiscal imbalances. However, reducing the government expenditure is a challenge. According to the traditional Keynesian theory, if one manages to reduce the government deficit, another problem sets in as a country might slide into a recession. Depression sets in due to the fact that budget deficits are never wrong at times despite their evil reputation. In essence, budget deficits showcase the efforts by the government to purchase commodities, paying wages to its employees as well as executing its transfer of funds to the less fortunate cohorts. As the government does this, it is pumping money into the economy besides enhancing the levels of economic activities (Hollander, 1987). Therefore, a sudden reduction in government expenditure despite the pursuit of a well-intentioned attempt to achieve a balanced budget, many suppliers will be left with a blank page in their respective order books, retrench the workforce and reduce the money supply in the economy. However, in rebutting the Keynesian assumption, the budget reduction might lead to lower interest rates, depreciation of currency and positive expectation effects offsetting and swamping the traditional undesirable Keynesian effects of budget reduction (unemployment and economic recession). As pointed out by the neoclassical economists, a smaller budget deficit lowers interest rates through diminishing perceived risk that a government decreasing its public debt via escalated future inflation based on government paying its debts through cheaper and inflated money. In such nations suffering from extremely large fiscal imbalances with economic actions projected as indispensable to recovering government solvency, reduction of budgets may lead to decrease in the default risk premium in interest rates (Meade, 1995). The neoclassical hypothesis advocates fiscal consolidation that results to increased public confidence in the government actions which culminates into reduced interest rates thus triggering investments both in the long run and during immediate periods of fiscal consolidation. Such consolidation makes the politicians convinced that reducing the budget deficit would not impose a severe penalty on economic growth hence less political inclination to derail reforms required in deficit nations. In this context, the Exchequer needs to adopt the increase in government spending on commodities as the best strategy to create full employment based on effective demand. Increasing government spending is an expansionary fiscal policy that leads to a rise in aggregate demand shifting the curve to the right. The aggregate demand is the total expenditure in the economy and is computed as, AD= C+I+G+X-M. The Chancellor should thus increase the government as the option for achievement of full employment as this will lead to increased demand for such goods thus attracting more factor inputs such as labours leading to increase in job opportunities and thus reducing the problem of unemployment. According to the analysis of the information given by the Prime Minister, there is an expectation a decrease in output and thus will lead to unemployment. Therefore increasing government spending will result in increased demand for the commodities hence increasing the productivity leading to increased production too much the increased aggregate demand. According to Keynesian, effective demand means that consumption expenditures are driven by actual income and not equilibrium income or full employment. The consumer spending are based on the disposable income which is available to the household sector rather than income that would be available for full employment. Effective demand asserts that consumers spend income that they actually have and not they could have in other situations. Therefore, changes in income particularly, the disposable income are the key influence on the consumption expenditures (Meade, 1995). With increased income for the household sector, the economy will expand and subsequently consumer spending increase. Less income for a household sector due to the economy is contracting, and large group of workers are unemployed, consumer spending decreases. Therefore, an expansionary policy of raised government spending is feasible than contractionary policy of increase in taxes. According to the classical economist, full employment is viewed as a normal situation in spite of recurring periods of observed unemployment. The classical economist believed in the economy’s ability to maintain full employment via its internal mechanism hence favouring the policy of laissez-faire (government by non-intervention). They held the view that the society should rely on the market mechanisms to take care of the economy and to restrict the role of government in areas where the community could positively contribute. However, based on the analysis of the figures projected in the Prime Minister’s letter, Keynesian view is feasible (Seidman, 2003). Keynes believed that production is embedded on expected demand and total spending thus invalidating the notion by classical economists that supply creates its own demand. Output responds to demand and not the converse as suggested by classical economist. The level of total spending in the economy could be inadequate to avail full employment and hence classical economist were misinformed to believe that interest rate adjustments and wage or price flexibility would restrict unemployment. Full employment is only possible when the level of total spending is adequate hence justifies the need by the Chancellor of the Exchequer to embrace increase in public expenditure in this case. Thus, in order to raise the employment as required by the Prime Minister, policies leading to adequate spending (increasing government spending and lowering taxes) are feasible so as to prevent unemployment. Therefore, the paper adopts Keynes assumption of obtaining full employment through focusing on the level of demand or total expenditures to determine the economy’s health. The expectation of the lower investment that that of the previous year possess a challenge to the attainment of full employment as well as productivity. Unemployment is thus looming as firms may retrench workers. The expansionary fiscal policy must thus be embraced. The government must hence increase its expenditure despite the fact that this will lead to government borrowing. Increase in expenditure by the government leads to a rise in demand for goods and services and thus triggering investment. With the gross fixed capital formation of 4 million pounds, increasing the spending by the government with simultaneous reduction in taxes is feasible as this automatically leads to employment of more workers that is also in line with the need to attain full employment (Sexton, 2013). Despite both classical and Keynesian economist being in agreement that the economy will always tend towards equilibrium, they fiercely differ on the amount of output at which the economy stabilized would provide full employment. According to the classical economist, the economy tends to maintain at a full employment equilibrium (potential GDP) whereas Keynesians believe that economy tends towards equilibrium but not necessarily at full employment. Therefore, unemployment equilibrium crops in where economy is in equilibrium at less than full employment (Baker & Bernstein, 2013). According to this context, there is unemployment and hence as pointed out by Keynesian assumption, the Prime Minister must embrace increase in government spending on goods and services without raising taxes so as to shift the aggregate demand curve to the right and increase the equilibrium level of real GDP and employment. On the other hand, the analysis of the international situation reveals an export expectation of more than 2 million pound with 20 percent of GDP as the imports (4 million pounds). The government through the Prime Minister must be keen in order to ensure there is a balance of trade as well as balance of payment. The economy will be hurt with this deficit BOP and hence the local, domestic production should be encouraged through increased demand for local goods via a rise in government expenditure. Increased government spending tends to grow demand, employment and consumption expenditures and thus leading to increased output which is also embedded in the working population hence movement towards full employment. Conclusion In conclusion, the analysis of the provision of the Prime Minister’s letter reveals an impending shortage of small output rising from reduced investments. Such challenges are a threat to the economy is they may culminate into increased unemployment. Therefore, the Chancellor of the Exchequer has adopted the increasing in government spending over increasing taxation to achieve full employment as well as to weed out the problem of deficit they may accompany such arrangements. Keynesian notion of achieving full employment by focusing attention on total spending is also preferred over classical laissez-faire concept. Therefore, in order to effectively control budget deficit, unemployment and deficit BOP, government intervention are justifiable. Calculations At full employment GDP=20 million pounds Imports= 0.2X20 million pounds= 4 million pounds Revenue from taxes= 0.2X20 million pounds=4 million pounds Budget deficit= Government expenditure- revenue from taxes= 4-4=0 pounds Balance of payment = export-import 2-4= -2 million pounds, negative BOP Word count: 1999 Reference Meade, J. E. (1995). Full employment regained: An Agathotopian dream. Cambridge [etc.: Cambridge University Press. Seidman, L. S. (2003). Automatic fiscal policies to combat recessions. Armonk, NY [u.a.: Sharpe. Hollander, S. (1987). Classical economics. Oxford [Oxfordshire: B. Blackwell. Baker, D., & Bernstein, J. (2013). Getting back to full employment: A better bargain for working people. Shaviro, D. N. (1997). Do deficit$ matter?. Chicago: University of Chicago Press. Sexton, R. L. (2013). Exploring economics. Australia: South-Western Cengage Learning. Read More