Fiscal Policy and Unemployment - Assignment Example

Macroeconomics Student name: Student number: Tutor: Date: 1. Factors leading to Long-Run Economic Growth One of the factors leading to long-run economic growth is abundant natural resources. Globally, countries depend on their natural resources for growth. For instance, United Arab Emirates and Saudi Arabia depend substantially on their oil reserves for growth of domestic product (GDP) (Kibritcioglu and Dibooglue 2001). Exploitation of these oil reserves for exportation of oil is therefore a critical means to achieving economic growth. Increased quality and quantity of raw materials would also leads to increased long-run economic growth. For instance, an increase in the number of viable oil wells in Saudi Arabia would lead to growth in long-run aggregate supply curve. This can be demonstrated graphically as shown below Figure 1: Corresponding growth in potential growth due to rise in LRAS From the above diagram, an increase in natural resources will cause long-run aggregate supply curve to shift from, LRAS 1 to LRAS 2, thus increasing the aggregate output from Y1 to Y2. The long-run trend rate determines the average sustainable economic growth rate over a particular period. It depends on the productive capacity growth in an economy and hence influences the long-run aggregate supply curve (LRAS). Therefore, long-term economic growth originates from increased quality and quantity of an economy’s factors of production. Growth is measured by an economy’s capacity to increase output (Kibritcioglu and Dibooglue 2001). Increased capital resource is also a critical factor. Investing in new technology (such as mass production machinery) is likely to increase efficiency, and ultimately shifting the long-run aggregate supply curve outwards, thus leading to long-run economic growth. Enhancing the capital stock, as well as utilizing it effectively results in long-run economic growth. For instance, Japan is known for having one of the faster growth rates due to its high capital investment. This led to the rise of multinational companies, such as Toyota and Panasonic, especially after the Second World War. However, the country experienced great economic recession in the 1990s, which affected its growth performance leading to decline in some of its companies. Still, capital investment is not necessarily sufficient. For instance, if Japan seeks to invest in declining industries, then such investment would be a waste. The increase in capital resource will also results in a shift of aggregate supply curve to the right, as shown in the figure 1 above, thus causing the aggregate output to increase from Y1 to Y2. Labor resource is a significant factor that leads to long-run growth of an economy. Increases size of labor and its efficiency also plays a critical role in that regard (Kibritcioglu and Dibooglue 2001). Greater size of manpower to handle work in factory is likely to promote greater participation rate, and ultimately greater output (Laubach 2003). However, there should also be increased quality of the manpower through more efficient training, education and the value of human capital, as these will make the workforce more productive. These increase the long-run aggregate supply curve. Further, effective government interventions, such as the supply side policies are likely to increase long-run trend rate. These policies seek to promote greater productivity by triggering better productivity (Kibritcioglu and Dibooglue 2001). In the United Kingdom, the supply side policies introduced by the government include cutting back of the power of the trade unions and privatization. These supply side policies may be interventionist or free market. In this regard, privatization consists of a free market policy since it boosts efficiency by eliminating the function of the government in the industry. Therefore, it could be reasoned that the private sector is driven by the profit motives, which make it more efficient than the government sector. Such increased efficiency can boost long-run economic growth. Advancement in technology increases efficiency of technology as a resource. For instance, efficient labor would lead to better productivity and minimal waste. In this regards, a significant factor of production is labor productivity. In case of improved training and education, then the human resource would be more productive, hence shifting the long-run aggregate supply curve outwards. An outward shift of the long-run supply curve implies a growth in aggregate output, which in turn results in long-run economic growth. 2. Using Fiscal Policy to solve Unemployment A fiscal policy refers to a form of macro-economic policy a government introduces to trigger aggregate demand. Such a policy makes use of government expenditure and taxation in the form of a tight or loose fiscal policy. A loose fiscal policy can be used to address unemployment since it involves reducing taxation and raising government expenditure. Still, there are limitations to the effectiveness of fiscal policy in terms of tackling unemployment. For instance, it only serves to decrease demand-deficient unemployment rather than frictional or structural unemployment (Battaglini & Coate 2011). Over the recent years, there has been a renewed interest in the application of fiscal policy to solve unemployment. For instance, after the Financial Depression in 2009, many policymakers in the United States and United Kingdom expressed optimism, in the use of fiscal policy to address the increased rate of unemployment. Still, some researchers have expressed reservation by arguing that the use of fiscal policies to solve unemployment is challenged by the high debts levels (Battaglini & Coate 2011). At any rate, it can be argued that fiscal policy can effectively solve unemployment based on the Keynesian perspective. From the perspective of Classical Economists, however, it cannot do so. From the Keynesian perspective, fiscal policy may come in handy during financial recession to reduce unemployment by increasing investment, triggering higher output and subsequently creating more jobs (Battaglini & Coate 2011). This implies that fiscal policy potentially reduces cyclical unemployment. For instance during the 2009 financial recession, the US government cutback taxes in the affected industries and increased government spending by giving out loans to the affected financial institutions. This stabilized the firms and solved the unemployment crisis at the time. On the other hand, if the Classical Economics perspective is taken into perspective, then it could be reasoned that fiscal policy may only temporarily lead to real output. In the long-run however, the expansionary policy contributes to inflation rather than lead to increased gross domestic growth (GDP). In any case, proponents of Classical Economics believe that solving unemployment is more feasible using the supply-side policies that promote flexibility of the labour market. Strategies in this regard include using deregulation policies to reduce the power of trade unions (Battaglini & Coate 2011). For instance, to curtail the high unemployment rate in Australia’s tourism and hospitality industry (due to inflexibility of the sector) in the 1990s, the federal government introduced deregulation to give the employees more bargaining power, leading to the introduction of Workplace Relations Act in 1996, and the Work Choices law in 2005. The flexibility enhanced increased employment in the sector. In this respect, fiscal policy ineffectively addresses supply-side unemployment. In situations of structural unemployment, fiscal policy may not address unemployment. For instance, when a South African diamond mining firm sacks many of its employees, leading to a high rate of unemployment in the country, the problem may be geographical immobility and lack of the desired expertise rather than financial. Under this situation, supply-side policies (rather than fiscal policies) would effectively solve unemployment (Battaglini & Coate 2011). To conclude, it is critical to argue that to a greater extent, the fiscal policies do not necessarily solved unemployment, especially when the unemployment in question is supply-side unemployment. 3. Effects of increased Interest Rates Interest refers to the money that financial institutions or creditors are paid for the loan repaid by a borrower. On the other hand, interest rate is the proportion of the amount of loan that the creditor charges for the money he lends. Increased interest rates bring both negative and positive effects to an economy. In the United States, the Federal Reserve Board sets the interest rates (Anderson et al 2014). When the Federal Reserve Board alters the rates at which banks can borrow money, the effects can be both positive and negative. When the Federal Reserve Board is concerned of a likely increase in inflation, it may increase the interests rates (Laubach 2003). The purpose would be to reduce the demand for money and enhance the economic growth rate. Often, when the interest rate is increased, it triggers higher commercial rates. To this end, increased interest rate has several implications to an economy. Increased interest rate increases the cost of borrowing. For instance, by increasing the interest rate, the interests on loans and credit cards are also increased, which discourages borrowing from financial institutions (Laubach 2003). At this rate, individuals who already have loans are likely to have less disposable income since they will be compelled to spend more on paying the interest. Increased interest rates also increase the prices of bonds. Businesses and government raise money by selling bonds (Anderson et al 2014). Therefore, when the interest rates are increased, the cost of borrowing also rises. This implies that the demand for low-yield bonds is likely to decline, which influences a fall in their prices. This will increase the demand for high-yielding bonds, hence causing the prices of bonds to increase (Thoma 1994). Increased interest rate also increases interest payment of mortgage. This is likely to affect the rate of consumer spending. For instance, when the interest rate is increased by 0.5 percent, it can increase the cost of $100,000 by $60 each month, which can have a substantial effect on an individual’s disposal income. Additionally, increased interest rate reduces an individual’s spending. Instead, it increases the individual’s incentive to save in a bank due to the high interest expected (Anderson et al 2014). Increase interest rates also increase the value of US Dollar. Hence, investors will have more incentive to save in US banks since the rates in the United States are higher compared to the foreign banks. Stronger US Dollar also makes US exports less competitive. Hence, imports are encouraged and exports reduced. In such a case, the aggregate demand in US economy is likely to be reduced. Businesses and consumers are also likely to be affected by high interest rate. Ultimately, the economy is likely to witness declined investment and consumption. The government debt interest is also likely to be increased (Anderson et al 2014). For instance, if the United States pays more than $700 billion a year on the national debt, higher interest rate is likely to increase the interest the government has to pay. In reaction, the government may impose higher taxes. This means that it affects the business and consumer psychology, since the two are likely to cut back on their spending. It may cause reduced confidence on the consumer or business. Since increased interest rate will lead to low investment, businesses are likely to be reluctant to make risky investments, while consumers will be less enthusiastic about making risky purchases (Laubach 2003). This causes the earnings to reduce and the prices of the stocks to drop, thus causing the aggregate demand curve to shift inwards from AD1 to AD2. Conversely, when the interest rates fall substantially, the businesses and consumers will increase their spending. The figure below shows the effects of interest rates on AD. Figure 1: AD/AS diagram showing in increased interest rate However, the higher interest rates affect the consumers differently. The impacts of increased interest rates do not affect the consumers in a similar manner. For instance, the consumers with huge mortgages are likely to be affected greatly by increased interest rate. For instance, when inflation is reduced, it will require that the interest rates rise to a degree that causes consumers with huge mortgages to witness hardships. Despite this, consumers with savings may be cushioned from the hardships (Anderson et al 2014). . 4. Difficulties faced in Controlling Inflation. In inflation, the prices of commodities increase and declines in response to the trends of supply and demand (Basu 2011). A country's central bank and other economic policymakers such as the ministry of finance and the Treasury take charge of managing inflation. In the United Kingdom for instance, the Bank of England uses different methods to reduce inflation. For instance, it may change the interest rate to maintain inflation within the set target of 2%. However, the process of controlling inflation faces several difficulties (Pétursson 2008). First, prediction of the future trends of inflation may be a problem. This is based on the assumption that when the government and the treasury are well informed of the future economic trends, they can forecast inflation and change the source of inflation in future (Basu 2011). For instance, if the Bank of England perceives the current economic trends as having negligible threat of increased inflation, it may decide to maintain the interest rates. Despite this, there may be unexpected rise in AD because of the rise in consumer and investor confidence. At this rate, inflation may rise before the Bank of England has sufficient time to increase the interest rates (Pétursson 2008). Cost push factors also limit the effectiveness of monetary policy in controlling inflation. In the event that cost-push inflation rises, aggregate supply will shift to the left leading to declined growth and higher inflation. A conflict between different objectives is likely to occur under such circumstances (Basu 2011). For instance, when inflation rises to 5 percent in the United States, the Fed may decide to reduce the interest rates since they believe that the inflation is temporary because of the high tax rates, and second, since the government wanted to avoid recession. However, the effect is that it contributed to higher inflation (Thoma 1994). Time lags also cause difficulties to controlling inflation. The problem of controlling inflation may be aggravated by the challenges of time lags. When inflation rises, the Bank of England may decide to increase the interest rates (Basu 2011). Still, the time lag is a critical factor, since it may take up to 20 months before higher interest rates finally reduce demand. Hence, the decision to raise the interest rates may be late. In which case, when the Bank of England increases the interest rates, it may take some time before it eventually reduces AD. This also means that an effective monetary policy should ensure that the inflation trends are predicted effectively. This may however not be the case (Pétursson 2008). Next, the higher interest rates may fail to effectively reduce inflation when other elements of aggregate demand rise. For instance, in the 1980s, UK experienced problems with reducing aggregate demand by increasing interest rates since consumer and investor confidence were high, hence consumers had a strong willingness to borrow the higher interest rates notwithstanding (Basu 2011). In the event that a supply-side shock exists in the economy, it may make it more difficult to lower inflation since higher interest rates reduced the GDP further (Pétursson 2008). As indicated in the figure below, in case there is a substantial rise in the price of raw materials, then the LRAS would move to the left. Figure 2: price of raw materials rises and LRAS move to the left. This will reduce Real GDP and increase inflation. To lower inflation through interest rates, a lower AD would be triggered. Therefore, it would result to a significant decline in Real GDP to Y3, thus increasing inflation further. Reference List Anderson, G, Bunn, P & Pugh, A 2014, “The potential impact of higher interest rates on the household sector: evidence from the 2014 NMG Consulting survey," Quarterly Bulletin vol 4, pp.419-433 Basu, K 2011, Understanding Inflation and Controlling It, viewed 17 Jan 2015, Battaglini, M & Coate, S 2011, Fiscal Policy and Unemployment, viewed 17 Jan 2015, Kibritcioglu, A & Dibooglue, S 2001,"Long−Run Economic Growth: An Interdisciplinary Approach," Business UIUC Working Paper 0-1-0121 Laubach, T 2003, “New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Federal Reserve, viewed 17 Jan 2015, Pétursson, T 2008, "How hard can it be? Inflation control around the world," Central Bank Of Iceland Working Papers No. 40 Thoma, M 1994, "The Effects of Money Growth on Inflation and Interest Rates Across Spectral Frequency Bands," Journal of Money, Credit and Banking, vol 26 no 2, pp. 218-231 Read More