Business Cycle, Fiscal Policy, and Other Questions - Assignment Example

Business cycle, fiscal policy and other questions Table of Contents Business cycle, fiscal policy and other questions 1 Table of Contents 1 Explain the link between the levels of unemployment, inventories and plant utilization during the expansion and recession phases of the business cycle. 2 What is the correct fiscal policy stance for a depressed economy and what budget implications does it have? 4 What is the expected outcome of the fiscal policy in the Australian economy in 2012? Illustrate your answer with an appropriate graph. Discuss the impact on all the macroeconomic objectives. 7 What problems may occur with the operation of fiscal policy 11 so that it does not achieve the desired outcome? 11 References 12 Explain the link between the levels of unemployment, inventories and plant utilization during the expansion and recession phases of the business cycle. Inherent fluctuations in economic activity are what connote the business cycle in a broad term. Macroeconomics has a long tradition of measurements of business cycles and the founder of the National Bureau of Economic Research (NBER) Wesley Mitchell (1927) first provided a framework for the same. Both defined business cycle in terms of alterations between periods of recession and expansion, which are considered as two alternating phases of the cycle. In other words, economic activity's transitory fluctuations from a “permanent trend” constitute these changes. In this cycle recessions lead to transitory fluctuations in output that are negative; although the fluctuations might differ in magnitudes and shapes depending on the type of cycle involved. An asymmetric shape is closely linked to unemployment, measure of economic slack and capacity utilization. This holds true even when univariate analysis pertaining to the gross domestic product is used to measure the cycle. In the macroeconomic parlance this is known as a model-averaged business cycle which involves univariate dynamics of the real GDP. Level of capacity utilization and unemployment rate are considered as the two important variables of this cycle. These two variables are presumed to move as the business cycle moves but cannot be said to provide broad measures of real GDP's economic activity (Hamilton, 1989). Typically levels of unemployment, inventories and plant utilization move along with the four phases of the business cycle which are peak, recession, trough and expansion. The fluctuations entail economic shocks, decrease in employment and output, and sticky downward prices. Furthermore, unemployment creates a clutter in the types of efforts unemployed take, which include individuals who are either searching jobs or looking to take jobs soon; individuals who are struck by structural unemployment problems involving changes in the demand for workforce; and individuals who are struck by cyclical unemployment issues typified by the recession phase of the business cycle. Those hurt by the fluctuations include fixed-income receivers, savers and creditors. Similarly inventory behaviours provide an insight into the business cycles even though they do not have a major role to play in the component of output. This, however, should not go unnoticed that there has been considerable interest in inventory investment in macroeconomics on account of its significance that policy makers and macroeconomists find important. One reason for this could be a simple assumption that even if inventory investment relative to GDP is quite small, fluctuations in the same are not as small as the ones relative to GDP. In other words, inventory investment rate changes in a quarter are more than the changes encountered in GDP in the same quarter (Bils and Kahn, 1996). There is a close association between the movements in output and movements in inventory levels, where inventories lead output slightly. That apart, on an average, changes in inventory holdings are 60 percent the changes in output on a quarterly basis. Blinder (1990, p. viii) has remarked that business cycles can be said to be inventory cycles to a surprisingly large degree. Inventories are said to play buffer-shock role in production if sales are stochastic. This is because of the inference that unexpected increases will be responded to by the firms by inventory holdings reduction and production increase. The production increase will invariably be less than sales. If the production decision is taken by a firm before the sales shock is observed, then inventories will solely determine the increase in sales. Certain empirical findings have suggested that there is a positive correlation between investment and output, and that sales are less variable than output. This is true particularly when data used are less aggregated. These findings have been observed to be held when industry-specific data is used specifically (Blinder and Maccini, l991; West, 1986; Blanchard, 1983). What is the correct fiscal policy stance for a depressed economy and what budget implications does it have? Discretionary fiscal policies' efficacy have evolved greatly for the last seven decades and particularly since Keynes popularized his General Theory in 1936. Two historic events of World War II and Great depression led to a unanimous opinion among economists that fiscal policy is directly related to the mitigation of economic downturns in the business cycles. Ever since the Keynes's theory it has now come to be known almost like an epithet when someone says that a nation or an individual is Keynesian in economics. Though it cannot be held that Keynesian economics always works, and since it does not, it is held that if it does not affect real income, it certainly does have an impact on nominal income. Aggregate economical demand in a country is influenced by the use or change in fiscal policy. This is done in order to achieve certain objectives like full employment, price stability, and economic growth. This is keeping in line with Keynesian economics which has suggested that aggregate demand can be stimulated when tax rates are decreased and government spending is increased. Once the economic boom begins the process is reversed in which taxes are increased while spending is decreased. This method is considered to be of high efficacy in times of low economic activity or recession. The method ensures that economic growth is fueled by this framework. Theoretically the deficit that results would be met by the boom through an expanded economy. Budget surplus is used to accomplish mainly two objectives. One is to stabilize prices at the high inflation levels and second is to slow the economic growth when it is exceptionally strong. Keynesian theory has argued that when spending is removed from the economy, it contracts the economy and thus reduces aggregate demand levels. The effect thus produced reduces prices. The report in The Australian, “IMF Warns Global Recession in 2012 ‘can’t be ruled out’”, is all about changing economic policy in order to avert 2012 economic downturn (Associated Features Press, 2011). Effectiveness of fiscal stimulus has long been debated by the economists, and the debates are mostly pertaining to what is termed as crowding out. It is also debated whether higher interest rates are a direct outcome of government borrowing which, inversely, has an impact on spending that is stimulative. During a budget deficit scenario, public borrowing is used to ensure flow of funds besides monetizing debt or resort to overseas borrowing. Interest rates in the money market increase when deficit is funded by the government by issuing bonds. This is because credit gets in higher demand mode since government starts borrowing in the financial markets. Interest in fiscal policy was reawakened after the 2008 global economic crisis. While countercyclical fiscal stimulus was seen as a widespread measure during the early phases of the crisis, the subsequent euro area crisis has triggered the need for macroeconomic stability and long-term fiscal sustainability. This has drawn the attention of economists towards the importance of fiscal policy so that long-term development and growth can be achieved. Developing countries see this as a potent instrument since there has been widespread and unabated sluggishness in the developed countries. Consequently since developing countries have used fiscal policy to check the crisis to some extent, the same is being seen as a model that could work in the global scenario. A number of policy lessons have been learnt from this. The change is fiscal policy in times of depressed economy has also seen greater acceptance since these nations which entered the crisis in stronger financial and macroeconomic position. Such a position has been attributed to their smaller current account and fiscal deficits, greater international reserves, comparatively lower inflation, low external and public debt and financial sector vulnerability that was less (Canuto and Giugale 2010; Kose and Prasad 2010). In countries having middle-income revenues, general government debt media ratio to GDP halved by almost 50 percent, while the fall was seen as precipitous in countries having low incomes. It all depends on how much is a country's fiscal space; greater the space better were they in a position to bring about countercyclical fiscal stimulus (IMF 2010a, 2010b; Aizenmann and Jinerak 2010). Previously it has been seen that many economies have resorted to greater countercyclicality as a stance in their fiscal policy. This has been in contrast to the past practices in which countries were procyclical on one hand and on the other expanded fiscal stimulus during good economies and shrunk the same during recessions and downturns. The observation by Vuletin, Vegh, and Frankel (2011) attempt to prove this point as according to them there has been a great increase in perusal of countercyclical fiscal policies particularly in the developing countries one-third of which used it during 2000-2009 as against mere 10 percent during 1960-1999. The application of countercyclical fiscal stimulus, however, will largely be determined on the basis of individual characteristics of an economy and cannot be generalized for all nations. The budget implications can be gauged by the sub-Saharan Africa crisis and the lessons learnt from it. A number of African economies witnessed remarkable improvements in fiscal and economic performance around a decade prior to the crisis. In comparison to early 1990s nearly 70 percent of these African economies were resting on primary fiscal surpluses. As a result of this there was a sharp fall in their public debt-to-gross domestic product ration. This was on account of both fiscal adjustments and debt relief. Arguably there is a need to develop a sustainable fiscal position and maintain it prudently during medium term. That means if an economy builds up greater fiscal space during the boom, it would need to make lesser budget adjustments during a downturn. Economists have repeatedly argued that it becomes difficult for nations to set a reversal in motion on discretionary fiscal measures taken up during a crisis after the crisis is over and boom has reappeared. This is why many nations, even when boom has returned, find it difficult to create safety nets that could act as a protective cover in the long-term or when there are temporary phases of downturns. What is the expected outcome of the fiscal policy in the Australian economy in 2012? Illustrate your answer with an appropriate graph. Discuss the impact on all the macroeconomic objectives. The European troubles have been major sources of reportage world over and as much as in Australia. Forecasts for world growth were lowered by International Monetary Fund (IMF) in January this year with an expectation that there would be a little over 3 percent increase in global GDP. Even as this rate is being dubbed as being within normal outcome range, it still is below average. But it certainly is not as dismal as it was recorded in 2009 (graph below). The downward revision has been a result of European developments, where fiscal policies are witnessing a fundamental shift. Australian economy at the moment is influenced by several factors emanating both from within and outside of the country (Debelle, 2012). The notable influences include European sovereign debt problems, housing market softness, and spending patterns of households. But if this scenario is viewed from the Australian point-of-view, profound effects are being felt from at least two factors. These factors, on the one hand, are very high exchange rate and, on the other, terms of trade and investment boom. Last year the country saw an increase of 20 percent in the business investment sector and a boom is also underway in the resource sector. The silver lining is that a double digit increase is expected by the Reserve Bank of Australia over the next few years. Analysts believe that when such a thing happens, the GDP-investment ration will show an attractive margin (graph below). It is probably factors as these which determine the appreciation of Australian dollar despite a weak outlook prevailing globally. When inflation rate difference is adjusted across countries, it would not be an exaggeration to say that the country is witnessing an impressive exchange rate of the last 4 decades. It can be deduced that Australian at the moment is undergoing fiscal consolidation in a widespread manner and also witnessing enormous development in emerging markets – high exchange rate, boom in investment; both of which lead to terms of trade that are of high level. Despite the powerful European economical forces, analysts have seen Australia enter its economy in a comfortable manner early this year. The nation feels the trend would continue since there is a consistency in inflation with respect to target and growth has been a continual phenomenon (Lowe, 2012). Australian fiscal policy has attempted to meet primarily three major objectives in the recent years. These include internal balance, economic growth, and external balance in terms of its economy. These three objectives work together to establish economic growth nationally while limiting the liability and foreign debt size and maintaining low inflation. Australia's fiscal policies have been such that its macroeconomic management is able to either cope up with business cycle fluctuations or handle them better. Low unemployment and low inflation are being considered as two major components work in this favour. However, on account of certain limitations like that of demand-side nature, it is not possible for the country to use macroeconomic policies so extensively. This is why this is used with reforms that have a supply-side influence. Since this way the country influences demand, it is able to use both instruments of monetary policy and fiscal policy concurrently. Australia uses government budget through its fiscal policy so that it could meet its objectives by controlling government revenue and spending. In other words it alters economic activity level with a fiscal deficit, fiscal surplus or a balanced budget. This means a two-pronged approach in which both budget and economy influence each other in terms of outcomes (Nguyen, n.d). What problems may occur with the operation of fiscal policy so that it does not achieve the desired outcome? If this question is seen in context of The Australian report which did not rule out global recession this year, it could be said that such a thing would have its genesis in Europe's lack of common fiscal policy and inter-country labour mobility. Realm of fiscal policy is the most obvious difference in Eurozone. For example, there are differing fiscal policies between North and South of the Eurozone. While fiscal austerity was embraced by North in conjunction with a strategy that promoted unit cost control and export-oriented growth; South – especially Portugal, Italy, and Greece – did not go by that rigor (Carlin 2012). Lower interest rates which might seem to offer a less fiscally prudent opportunity could act as a monstrous bubble later and confront with private debt that is rising by the day. This is what happened in Ireland and Spain where the rising debt and housing bubble rose like a giant problem. Similarly public debt rose when fiscal probity masked the reality. The result was collapse of banks and subsequent recession. These are instances when fiscal policies can go horribly wrong and lead to really undesired outcomes. Economists opine that fiscal outcome can be directly related to executive fragmentation as propounded by Kontopoulos and Perotti (1997). Executive fragmentation is of vital important both statistically and economically to fiscal outcome. On the other hand if legislative fragmentation comes in the way of fiscal policy decision-making – even if it is not as robust and important as executive fragmentation – it can lead to negative outcomes. This is what explains the success of fiscal outcomes in early 1980s when the policies were driven by executive fragmentation, based on the cabinet size. In the later years when it started getting influenced by coalition size or legislative fragmentation, the association was less impressive and less robust. References Aizenmann, J., and Jinerak, Y. (2010). “De Facto Fiscal Space and Fiscal Stimulus: Definition and Assessment.” Working Paper 16539, National Bureau of Economic Research, Cambridge, MA. Bils, M., and Kahn, J.A. (1996). “What Inventory Behavior Tells Us about Business Cycles,” Rochester Center for Economic Research, Working Paper No. 428, September 1996. Blinder, A.S. (1981). “Retail Inventory Behavior and Business Fluctuations,” Brookings Papers on Economic Activity, vol. 2, pp. 443–505. Blanchard, O.J. (1983). “The Production and Inventory Behavior of the American Automobile Industry,” Journal of Political Economy, vol. 91, no. 3, pp. 365–400. Carlin, W. (2012), “Real exchange rate adjustment, wage-setting institutions, and fiscal stabilization policy: Lessons of the Eurozone’s first decade”, CEPR Discussion Paper No. 8918. Canuto, O., and Giugale, M. eds. (2010). The Day after Tomorrow: A Handbook on the Future of Economic Policy in the Developing World. Washington, DC: World Bank. Debelle, G. (2012). ‘On Europe's Effects on Australian Financial Markets’, Address to Bloomberg Seminar, Sydney, 14 February 2012. Frankel, J., Carlos, V., and Vuletin, G. (2011). “On Graduation from Procyclicality.” Working Paper 17619, National Bureau of Economic Research, Cambridge, MA. Hamilton, J. D. (1989). ‘‘A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle,’’ Econometrica 57:2, 357–384. IMF (International Monetary Fund). (2010a). “Emerging from the Global Crisis: Macroeconomic Challenges Facing Low-Income Countries.” October 5. IMF (International Monetary Fund). (2010b). “How Did Emerging Markets Cope in the Crisis?” June 15. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money London: Macmillan. Kose, M. Ayhan, and Prasad, E. (2010). Emerging Markets: Resilience and Growth amid Global Turmoil. Washington, DC: Brookings Institution Press. Kontopoulos, Y., and Perotti. R. (1997). Fiscal fragmentation. Columbia University. Retrieved http://www.nber.org/chapters/c8024.pdf. Accessed October 17, 2012. Lowe, P. (2012). The Forces Shaping the Economy Over 2012. Retrieved http://www.rba.gov.au/speeches/2012/sp-dg-160212.html. Accessed October 17, 2012. Nguyen, D. (n.d). “Macroeconomic Policy in Australia”. Retrieved http://www.kewpid.net/notes/macro_reform.pdf. Accessed October 17, 2012. Wesley, A.M. (1927). Business Cycles: The Problem and Its Setting. New York: National Bureau of Economic Research. West, K.D. (1986). “A Variance Bounds Test of the Linear Quadratic Inventory Model,” Journal of Political Economy, vol. 94, no. 2, pp. 374–401. Read More