Why Stimulus Will Mean Inflation - Assignment Example

Government borrowing is too high and interest rates are too low in many countries; fiscal stimulus does not work and cheap money leads only to inflation’. Critically evaluate this view of the policy response to the economic crisis using appropriate theory and evidence.   Introduction: The economic phenomenon of recession is a part of the economic cycle which all ecologists believe a capitalist market experiences after a certain point of time. The phenomenon of recession can be described as gradual decrease in the economic activities in the market or as the contraction of the business cycle experienced by an economy over time. There are various changes that come about in the macroeconomic factors of an economy in a similar fashion during the period of recession. It is observed that the factors such as the GDP, the employment rate, the investment rate, and the business profit all face a downhill scale during this economic period. If one was to go by the Keynesian theory, a fall in AD then will mean there will be a fall in Real GDP. The level of confidence level of the consumers in the economy is usually taken as the basic factor on which the rate of economic growth is calculated. In fact most of the economists have stated that these two have a direct relation with each other. If the level of confidence that is faced by the consumers and the investors in the market is high then interest rates may not reduce, yet at the same time the opposite also holds true. If the consumers feel that they will soon be unemployed then they spend less, and due to this the AD in the economy starts to fall. Therefore this shows that expectations are very important and it is possible for “people to talk themselves into a recession”. One would also need to be understood that output and price are jointly determined by aggregate supply and aggregate demandThe economists are however not completely united in their stand over the nuances of recession, and the role of certain factors and such are still a reason of dispute among economists. Most Classical Economists have had the belief that a fall in Real GDP will be short term and will end when labour markets adjust to new price readings. They further argue that if there is a fall in AD will be manifested, in the short run as a fall in real GDP. Body: Where the Keynesian theory of economics, which was dominant from 1945-1970s, explaining public debt and funding is concerned, the primary factor to be considered is that of spending. This would signify then that capital and assets are thought of as being homogeneous entities where the impact they have on the overall transaction in the economy is concerned. The idea is that the advantages’ that are derived by capital expenditures is from the spending itself, not what capital represents. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income’ (Keynes, 1936, p.27). Thus, Keynesians would hold that in a time of high unemployment, if government borrows a load of money in order to build a bridge or road to nowhere that is perfectly acceptable because it causes government to spend, which “creates jobs” and places money into the hands of people who then are allowed to spend it. During times of recession, one of the primary ways in which the government id able to bail the economy out of the slump that it is in, is to increase spending. This tends to take the shape of increased government spends on infrastructure, or even as has been the case of bailout packages that have been deployed by governments the world over during this recession. Keynes developed his fiscal policy theories during the Great Depression. His belief was that the forces of supply and demand operated too slowly on their own in such a recession. Unemployment meant people had less to spend and because they could not buy things, businesses would tend to fold, leading to the creation of additional unemployment. It was a vicious cycle. Keynes’s idea was simple-in the light of such circumstances, the government should try to step in undertake spending that is needed to return the economy to its normal state. According to Keynes also, there is...no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment...The economic system cannot be made self-adjusting along these lines’ Where the concept of borrowing in such a scenario is concerned, the idea is that, it could be financed in several ways, including increasing taxes and borrowings. For government spending to gave the effect that Keynes wanted, it would be automatically essential that the spending be financed by borrowing, and not by taxes, because an increased burden on taxation would automatically then reduce the flow of cash in the hands of the public (Bhatia, 2009). The idea therefore is that government spending based bailout from the grips of a recession has to work based on the money that the government borrows from the people (Novarro, 2005). In most cases, businesses tend to constantly borrow funds to expand future production. In a recession, the government has little competition in the credit markets, and its borrowing stimulates the economy.  Government borrowing is now two and half times higher than at the same point last year after a record £16.1bn was borrowed in August. In general, we cannot assume that price is given and determine output by aggregate expenditure alone , while aggregate supply is a constraint Consumers also borrow to finance items that cannot be paid for out of current incomes such as a house or a car. In a recession however, borrowing tends to slow down. Businesses may not believe that they have the ability to sell the new goods or services that would allow them to repay the funds they might borrow, consumers may be fearful of incurring long-term obligations at a time when their jobs might be threatened. When the government borrows during a recession, the borrowing, is, in essence an attempt to replace the borrowing that businessmen and consumers would normally undertake. By running a budget deficit, therefore, the government makes up not only for reduced spending by consumers and spenders but for reduced private borrowings as well (Schmidt et. Al., 2010). The problem however arises, given the fact that given the huge public borrowing numbers that have been rakes up in the US and UK, the issues now has become one concerned with fiscal deficit and slashing of public spends, which in the next five years will affect non-negotiable variables such as education, health and social security (The Independent, 2010; Time Magazine, 2010; Hoffinger, 2009). Along with this, one also keep in mind the fact that the there is always present the threat of double dip recession (Goldberg, 2008). This the governments seem now to be determined to deal with, by permanently extending taxation benefits that were made during recession. For much of the third world, and BRIC countries such as India, the budget deficit has had to be supplemented through sale of state assets in the form of disinvestment. When a business borrows money or capital, it does so with the idea in mind that the business will make profits n the future and they just do not borrow the capital just to spend it but look upon it as an investment. Instead, they are engaging in purposeful, future-oriented behavior. Contrast this with the current wave of government borrowing. Most of the "stimulus" money is for projects that really have little value for capital expenditure purposes (Krugman and Obstfeld, 2008). Moreover, it has been proven that real money supply (M/P) does depend on the price level Where fiscal stimulus packages are concerned, most were introduced keeping in mind an assumption that they would be wrapped up by within a year or so (Regional Economic Outlook, 2009). The packages were relatively large-the American stimulus package for example pumped in sums to the tune of $800 billion into the economy, which ultimately ended up increasing the fiscal deficit and replaced us jobs with foreign ones (MSNBC, 2010). The ultimate goal of the stimulus package ended up as saving banks that were on the verge of bankruptcy due to corporate greed (FitzRoy and Herbert, 2009). Despite the package over the past two years, over 500 banks have folded business in USA. Much of the developing world has been able to keep itself insulated from recession relatively because of measures of market restrictions and protectionism. Also the stimulus signifies inflation given the excess money which is artificially pumped into the economy. Countries such as India again have been grappling with inflationary pressures exceeding 12 per cent over the last year. Dealing with huge fiscal deficits has been possible on the part of the government by printing more and more all of which results in inflation, given especially the fact that Fed's outpouring of dollar liquidity after the September crash replaced the liquidity lost by the financial sector.  While one understands the fact that inflation could be understood as being the product demand for money, it is as much a factor associated with supply. With the Federal Bank, financing deficits in a moribund economy, the result has been the creation of more money that could possibly be used by the economy. What one sees today therefore is "stagflation," a term coined to describe the 1970s experience (Wall Street Journal, 2010).  Conclusion: In conclusion therefore one could reiterate the fact that while there is truth to the statement, one would need to consider the fact that in keeping with the traditions of macro-economic theory, inflation might be a long term impact of a set of measures that could be defined as being essential steps by governments the world over to deal with the Global recession.   Reference:  Schmidt S. W., et. Al., (2010). American Government and Politics Today - Texas Edition, 2009-2010. Cengage Learning. p607  Bhatia, S. C., (2009). Retail Management. Oxford Books. p454  The Coming Tax Cut Showdown. Retrieved November 12, 2010,   Cut from the banks to tackle deficit, not child benefit. Retrieved November 12, 2010,   Regional Economic Outlook. (2009). Regional Economic Outlook: Asia and Pacific Global Crisis: The Asian Context. International Monetary Fund.p205  MSNBC Report. (2010). The stimulus worked — but for which party? 'The failed stimulus' has become a Republican mantra this election season. Retrieved November 12, 2010,   Wall Street Journal, (2010). Why 'Stimulus' Will Mean Inflation. Retrieved November 12, 2010,   Krugman, P. R., and Obstfeld, M., (2008). International economics: theory and policy. Pearson Addison-Wesley. What are the causes of a recession?, retrieved November 14, 2010 Recession explained, retrieved November 14, 2010 Krugman’s self explanation. Retrieved November 14, 2010 Withering shoots? Retrieved November 14, 2010, < http://www.business-standard.com/india/news/withering-shoots/363952/> FitzRoy, P., and Herbet, J., (2009). Strategic Management: Creating Value in a Turbulent World. Wiley Books. P76 Navarro, P., (2005). “The well timed strategy: Managing the Business Cycle”. California Management Review. Vol.48. pp72-73  Hoffinger, D., B., (2009). U.S. Bank Stocks and the Subprime Crisis. GRIN Verlag. p65 Goldberg, R., (2008). The Battle for Wall Street: Behind the Lines in the Struggle. Wiley Books. p113  Read More