Policies Government can use to close Deflationary Gap - Assignment Example

Policies Government can use to close Deflationary Gap Generally, deflation is a decline in the price level in an economy; it is a reverse of inflation1. Some of its effects are: increase in fixed nominal income, growth of savings because of the reduced prices, and gains to creditors. Deflationary gap exists where the economy has insufficient demand to generate or stimulate full employment equilibrium2. The economy does not provide enough jobs and avenues for business because the present production level is not cleared in the market place. Figure 1: Showing Deflationary Gap. In the above diagram, the economy is at equilibrium at point E where demand is strong enough to clear total amount of goods and services being produced. Beyond this point deflation sets in; national output exceeds the expenditures on consumption, investment and that of government as well as ability to finance export. The difference between the national output given by Y and that of expenditure E is termed deflationary gap. Any gap that exists before the equilibrium level is called the inflationary gap. The existence of this disequilibrium means an excess saving over investment or more withdrawals than injections because economic participants actually spend less than the amount of income they earned hence, accumulation of inventories. This unwanted accumulation of inventories implies that firms will cut back on production, lay off workers, and income falls. Because income and consumption fall, and firms cut production whereby the actual inventories will be equal to planned inventories and planned spending equal to income at Equi. level"3 Policies to close Deflationary Gap Basically, there are two main policies that can be used to close deflationary gap. They are monetary policy and fiscal policy. Monetary policy is used to influence interest rates, inflation and credit availability through changes money supply in the economy. There are three tools through which this policy can be implemented: reserve requirement, open market operations and discount rate.4 On the other hand, fiscal policy involves the use of government expenditure and taxation to influence national output and expenditure. In this section, discussion will be centered on deflationary gap experience of Japan and United States, and Ethiopia. In the late 1990s, Japanese economy underwent a severe deflation resulting in weak demand, high unemployment rate, and steady reduction in the general price level. The country experienced steady reduction in both nominal and real GDP growth in fiscal 1923 after the Great Kanto Earthquake and in fiscal 1998, after the year in which Yamaichi Securities and Hokkaido Takushoku Bank collapsed.5 There is a belief that shifts from profit maximization to strengthening balance sheet which disrupts normal working of the economy perhaps the corporate sector stop borrowing the funds the household saved even with very low interest6. (Nakahara) says that the application of monetary policy brought about considerable improvement in the economy. Bank of Japan adopted the Zero Interest Rate Policy from February 1999 to August 2000 when the industrial sector grew considerably well; corporate profits were recovering, business fixed investment and private consumption were on the rise7. In addition, the Bank of Japan introduced open market operations with overall objective of tackling reducing interest rate. The bank planned more liquidity to be made available in the money market by maintaining the outstanding balance of current accounts at the bank at over 6 trillion yen and targeting interest rate below 0.01 percent. In the diagram below, the effect of changes in interest rate is employed by Bank of Japan in order to tackle deflation. At point E the economy is at equilibrium national product which is less than full employment. Point B represents the national output the economy produces where equilibrium exists at point E intersection of initial aggregate demand AD1 and national product NP while point F is the anticipated full employment output the economy hopes to attain. The deflationary gap, the difference between H and J, is what the bank intends to fill up. By reducing interest rate to 0.01 and even below, the businesses take advantage of the low cost of investment and then borrow to increase their productive base thereby stimulating the aggregate demand from AD1 to AD2. With the shift in aggregate demand curve, the deflationary gap suddenly disappears hence full employment is achieved at point H. In fact, Bank of Japan had to grapple with some more tools of monetary policy for this full employment to be attained, but on the whole the principal tool employed was variation in rate of interest. Figure 2: Showing effects of decrease in interest rate to national output. Japan equally applied fiscal policy in the management of the deflation dilemma its faced but it is believed that it did not help much to bring the necessary changes8. Kuttner contends that in the face of cut taxes and increase spending by government, deficit continues to grow and output growth minimal. In the years of the great depression, United States experience great deflation beginning in October 1929. During this time, stock market crashed, business houses closed, factories shut down, banks failed, income went low and unemployment was phenomenally high. Just like in the case of Japan, the aggregate demand was so weak that factories accumulate so much inventories. There was immense disparity between the country's productive capacity and the expenditure pattern. This is believed to be the result of great innovations in production techniques following the World War II; the emerging technologies raised production beyond the purchasing power of U.S. citizens9. However, Roosevelt used this as an opportunity by promising using government's authority to bring about solutions; of course he won the election with overwhelming supports of Americans. The Famous New Deal was launched which represented a long ranged trend in abandoning free market capitalism and adoption of regulation similar to the one of 1880s to bring about reduced unemployment, boost agricultural production, better organized labour. The first Deal seemed not to bring the desired imparts - did not end the deflation, Second New Deal was put in place to provide 'work rather than welfare' to the Americans. The deal was orchestrated by The Work Progress Administration which actually helped a total of 9 million people before it was abandoned in 1943. During this time famous economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money came up with use of fiscal policy to influence the economy and this was highly embraced. He opined that if macro equilibrium is below full employment equilibrium that deflationary gap exists in the economy10. To him the only way out are: a. Tax Cuts b. Increased spending by government. Figure 3: Showing effects of increase in government spending to national output. At initial equilibrium E, in which there is large-scale unemployment. National product B is less than the full employment national product at F. In order to reach full employment; government spending should be increase by HJ, the amount of the deflationary gap. This will shift the aggregate demand from AD1 to AD2 and move the economy to full-employment equilibrium at H. (Bloomqvist, et el 1987, pp 215) opine that when government does increase its level of expenditure, the multiplier effect once again will be put to work11. The multiplier effect means that the increase in government expenditure is capable of increasing a number of times in the economy. For full impart of the multiplier effect to be felt, it is hoped that taxes are not increased in order to cover up government expenses. If this happens then there is that tendency for crowding out to occur. Crowding out is situation in which government increased spending increases interest rate and displaces interest-sensitive private spending. Ideally, higher interest rates discourage or 'crowd out' private investment thereby reducing the expansionary effect of the deficit. Keynesians argue that during the great depression, aggregate demand was needed to restore full employment and to do this government must not necessarily increase tax in order to spend rather borrow so as to clear the deflationary gap. Though it may sound odd, if this stimulates aggregate demand and reduce unemployment, it is the best bet. Furthermore, Ethiopia experienced deflation between 1987 and 1988. The deflation was attributable to deregulation of the domestic economy, devaluation of the currency (the birr) by over 140 per cent and weaker bargaining power of the trade union. In Ethiopia both monetary and fiscal policies were employed to curb the deflationary trend. The National Bank cut discount rate to 12 per cent and hoped to further slash it down12. It is suggested that government could expand its use of fiscal stimuli so as to make investment attractive and productive. Limitations on the Policies There are a number of limitations inherent in effective implementation of either monetary or fiscal policy on deflationary gap. Japan experienced sharp practices with bank managers who borrowed money at 0.004 per cent and claimed to have borrowed at 0.002 per cent. Ineffectiveness of monetary policy stem from quantitative easing measure, private financial institutions reserves increased with the Bank of Japan. There is also existence of liquidity trap whereby even with money supply increased; it does not lead to reduction in interest rates, and there is little effect on the economy. Even in the face of nominal interest rates reducing to zero, if nominal GDP continues to decline as a result of deflation, the bad loan situation becomes worse as the debt burden of businesses increase relative to the sales revenue they earn. There is also the issue of "overbanking" - in which there is inordinately overdependence on bank loans to GDP. This heavy dependence implies that if banks fail to offer these loans, businesses then cannot produce the required output let alone employing to minimize the high incidence of unemployment13. (Sakakibara, 1993 pp 53-55) believes that problems of subcontracting amongst larger firms and small firms, overlapping hierarchies, and non-synchronization of policy planning and implementation with budget are capable of rendering monetary policy ineffective14. The major setback in the use of fiscal policy is the use of taxation to increase government expenditure. If this happens, the gains that the firms and households would have had now 'crowd out' out as discussed above. (Bloomqvist, et el 1987, pp 295) argue that when government increases it spending or cuts taxes, its deficit increases15. To finance its deficit spending, the government may decide to sell new bonds or short-term securities which imply borrowing from the financial markets. The additional borrowing drags up the interest rates and the higher interest rates in turn cause a movement along the marginal efficiency of investment (MEI) curve; the level of investment decreases. With the argument on crowding out raging between Classical and Keynesians, it is not empirically confirmed how much crowding out has occurred within what amount government may borrow. Finally, considering the Ethiopia experience of deflation and its application of both fiscal and monetary policies to remedy the situation; most of the above limitations may apply as well as some bureaucratic bottlenecks in the economy. Being a developing economy, policy implementation will often be greeted be time lag because of large informal sector. Bibliography 1. McConnel, C. R., Brue, S. L., & Barbiero, T. P. Macroeconomics. (9th Canadian Ed.), Toronto, McGraw-hill Ryerson. 2002 2. < http://www.bized.ac.uk/virtual/economy/library/glossary/glossarydf.htm> retrieved on 30th April, 2006 3. Nobuyuki Nakahara The Japanese Economy and Monetary Policy in a Deflationary Environment retrieved on 30th April, 2006 4. http://everything2.com/index.plnode_id=496113 retrieved on 30th April, 2006 5. retrieved on 1st May, 2006 6. Koo Richard, Japan's Lesson for America: a Comparison of Deflationary woes retrieved on 1st May, 2006. 7. http://www.drfurfero.com/books/2309book/ch12b.html 8. http://www.esri.go.jp 9. http://www.english.uiuc.edu/MAPS/depression/overview.htm 10. The Merced College. 30th April, 2006. 11. Bloomqvist, A., Wonnacott, P., Wonnacott, R. Economics. 2nd Canadian Edition, Toronto: McGraw-hill Ryerson. 1987 12. Hailu Degol, Deflation in a growing economy: The experience of Ethiopia retrieved on 1st May 2006. 13. retrieved on 1st May 2006. 14. Sakakibara, E. Beyond capitalism, the Japanese Model of Market Economics, Lanham, University Press of America Inc. 1993 15. retrieved on 1st May 2006. 16. Mceachern W. A. Economics A Contemporary Introduction, 2nd Ed., Cincinnati, South-Western Publishing Company. 1991 17. Baumol. W. J., Blinder A. S., Scarth. W. M. Economics Principles and Policy, 4th Canadian Ed., Toronto, Harcourt Brace & Company, Ltd., 1994 18. retrieved on 1st May 2006. Read More