The Global Financial Crisis and Countercyclical Fiscal Policy - Essay Example

Part Late one evening you receive a phone call from the President of the United s. She tells you that equilibrium real GDP is $8,000 and that the full-employment level of real GDP is $10,000. Ms. President, promising to make you her chief economic advisor, tells you that the marginal propensity to consume is 0.8 and asks you to provide a solution for the economy’s malady using only the government-spending fiscal-policy tool. What change in government spending will you recommend? Be specific and show all of your work. The real GDP at full employment means this is the long-term potential GDP for US = $ 10,000 Current equilibrium real GDP = $ 8,000 This means that there is a recessionary gap of Potential GDP – current GDP = dY = $2,000 The problem that needs to be solved is to close this recessionary gap. In order to close this gap, the governments needs to take some expansionary fiscal policy i.e. increase government spending and/or reduce taxes. If only government spending is to be considered, Let dG be the change in government spending to close this gap and dY denote the recessionary gap. Let mpc be the marginal propensity to consume, then dY = 1 dG (1 – mpc) This means that, dG = dY * (1 - mpc) = 2000 * (1 – 0.8) = $ 400 This means that in order to solve this problem, the government needs to increase its spending by an amount of $ 400. Part 2. At the end of your presentation, the president decides that any change in government expenditures would be politically unpopular at the moment, so she asks you how she might solve the same problem with a tax change instead. What change in taxation will you recommend? Be specific and show all of your work. Since there is a recessionary gap, the government would need to reduce the taxes. An increase in tax would mean lesser income available to spend. As the goal is to increase aggregate demand, taxes would need to be reduced. Cutting taxes will increase disposable income, which will stimulate consumption with multiplier effects & expanding output and employment. Let dT denote the change in taxes. Then we know that, dY = -mpc = - 0.8 = - 4 dT (1 – mpc) 0.2 This means that, dT = - dY/4 Then, dT = - (2000 / 4) = - 500 This implies that taxes need to be reduced by an amount of $ 500 in order to close the recessionary gap. So, it takes a larger deficit to get the same stimulus with a tax cut than it would with increased government spending. Part 3. Suppose that a balanced budget amendment forces the president to match each dollar increase in government spending with an equal offsetting dollar increase in taxation, and each dollar decrease in federal spending with an equal decrease in taxes. Would fiscal policy be weakened, or even rendered useless, by such a law? Why or why not? If the change in government spending is to be matched with equal offsetting change in taxation, the net effect on the GDP can be seen through the balanced budget multiplier (BBM) BBM = dY + dY = 1 + - mpc dG dT 1 - mpc 1 – mpc BBM = 1 – mpc = 1 1 - mpc This means that, for every 1$ change in government spending and the offsetting taxation change of 1$, the change in GDP is also 1$. The fiscal policy is not rendered useless as there is still change in GDP. If we look at the overall effect, the balanced budget multiplier allows us to close the gap without an increased deficit or decreased surplus. If, however, the recessionary gap to be closed is large, it would imply that the government needs to increase spending by a large amount, and also increase taxes by an equally large amount. This may not be very popular with the people and the government may be reluctant to enforce such a measure due to political reasons. So, such a law would actually weaken the fiscal policy. Part 4. Some economists worry that the size of recent and current budget deficits (and the rapidly accumulating public debt) could make countercyclical fiscal policy more difficult to use effectively in the future. What is their reasoning? Under what conditions would such an assertion be correct? Countercyclical fiscal policy (CFP) refers to government taking fiscal measures opposite to the cyclical tendency of the economy. So, the CFP is aimed at cooling down the economy during a boom and at stimulating growth during a downturn. Some economists however have pointed to certain reasons that make CFP less effective especially given the recent and current budget deficits: 1) One should have money before one spends it: Given the current deficits, if the government runs further deficit, this would mean that when the economy is back in boom, high taxes would need to be levied in order to balance the spending today. If due to political or other reasons, taxes cannot be raised further, the level of overall deficit will continue to increase making CFP unsustainable. 2) Deficits are inflationary: Government pays off its debt by printing more money. This leads to increase in the money supply, thus creating inflation. Also, this lowers the strength of currency forcing foreign governments to dump their reserves in that currency. 3) Crowding out effect: This refers to CFP leading to an opposite effect on private consumption. That is, if during a boom, the government reduces its spending or increases taxes, this reduces the overall demand and hence also interest rates. Lower interest rates then stimulate the economy. Similarly, if during downturn, the government increases its spending, it must borrow to make this expenditure. This leads increase in interest rates causing reduced private spending. For such an assertion to be correct, the conditions are: 1) Only fiscal policy is used to cover the entire deficits: meaning that the government does not use monetary policy but only fiscal policy (CFP) to cover economic gaps. 2) The size of gaps (recessionary and inflationary) is too large and government spending and taxation need to be drastic. 3) Deficits are used only to boost consumption and not production: If deficits boost only consumption, there is an increase in demand but no change in supply of goods and services leading to inflation. If however, the deficits are used to boost production, they increase the supply side thereby keeping inflation under control. Part 5. Should the federal budget be balanced annually? You may answer this question either yes or no and still receive full credit, but you must justify your answer. Refer to appropriate economic theory and the relevant “real world” considerations No, the federal budget should not be balanced annually. However, it should be balanced cyclically. The budget deficit can provide stimulus to overcome a turnaround and budget surplus can help keep the economic boom under control. If the budget is balanced annually, government spending would decline during downturn (to match the reduced tax income) and increase during economic expansion. The fiscal policy would be constrained in both cases to effectively control the economy. Balancing the budget cyclically is the reference to the Keynesian economics. If we look at the 2009 crisis, under an annually balanced budget regime, the government would have been constrained in passing tax rebates and other fiscal stimulus as the economy was in recession. Considering the volatility of the global economics, it is better to balance the federal budget cyclically rather than annually. References Dr. Haworth B. Closing output gaps with Fiscal policy. University of Louisville. Accessed 20 May 2011. http://www.econpage.com/202/handouts/AEmodel/fiscalpolicyuse.html Weil D. Fiscal Policy. The concise encyclopedia of economics. Accessed 20 May 2011. http://www.econlib.org/library/Enc/FiscalPolicy.html Weeks J. The global financial crisis and countercyclical fiscal policy. Centre for development policy and research. University of London. P 7-12. Will deficit spending lead inevitably to inflation? December 2008. Accessed 21 May 2011. http://www.blogvesting.com/2008/12/27/will-deficit-spending-lead-inevitably-to-inflation/ Read More