Government Intervention in Times of Economic Downturn - Essay Example

Government intervention: Introduction: This paper focuses on government intervention in times of economic down turn, the government has mechanisms to improve the current situation, and this involves the use of appropriate fiscal and monetary policies. Classical economists state that government intervention will only make things worse. Keynes (2007) on other hand states that the free market is not always efficient and the government has a role to play in ensuring that the market is efficient. In the great depression of 1930 government did little to solve the crisis, this depression was characterized by a decline in international trade, a decline in product prices, reduced consumer expenditure and unemployment. Many factors are said to be the cause of the depression which include the stock market that crashed in 1929, banks failure whereby consumers lost their savings and the failure by banks to provide new loans to stimulate expenditure and investment, reduction in spending as more people became unemployed, policies that were aimed at protecting local firms from international competition by imposing high tariffs on imports and the draught condition at the time. This paper focuses on the importance of government intervention in a recession. The paper draws largely on Keynes theory which explains the causes of recession and policy measure that are appropriate in a recession, the following is an analysis of the characteristics of a recession. Recession and depression: In the analysis of government intervention in a crisis it is important to first understand what are the causes and characteristics of a recession, recessions are not detected immediately and require observation of appropriate data for a given period of time, an economy has periods of contraction and expansion referred to as business cycles, there are periods when the economy output reaches a peak and periods when the economy contracts and this is referred to as a trough, after the peak the economy is said to be undergoing a recession. A recession may lead to a depression which is much worse, Marichal (1989) states that characteristics of a recession include: i. Crisis in the stock market ii. Increased unemployment iii. Reduced customer spending iv. Reduced income v. Reduced production Given the above characteristics of a recession it is evident that the governments have tools that can be used to improve the above situation; this will involve the use of appropriate measure to improve economic performance, unemployment, income and production. Government intervention: Fisher (1990) states that fiscal and monetary policies are used by policy makers to fine tune the economy, fiscal policies involves the use of government spending and taxation while monetary policies involves the use of interest rates, reserve ratio and money supply. As discussed above it is evident that the 1930 depression effects could have been reduced if policy makers applied appropriate policies at the time. An economy experiences business cycles whereby there are periods of economic expansion and periods of economic contraction, this means that production and output will expand in some years while contract in others, in the US for example business cycles are said to last for six to ten years, this means that during this period will be a period of prosperity and periods of economic downturn. Policies are used to ensure that a recession do not result into depression which much worse than a recession, fiscal policies used will be aimed at increasing aggregate demand which will result into increased output and employment, the following is an analysis of Keynes theory on stimulating aggregate demand. Keynes theory on government intervention: According to Keynes (2007) a recession is as a result of a reduction of aggregate demand in the economy, this results into an increase in unemployment and reduced output levels, he therefore advocates for policy measures aimed at increasing aggregate demand, the following is a discussion of appropriate measures that should be undertaken by government in a recession: Government spending: Keynes (2007) states that there should be an increase in government spending in a recession; a recession is characterized by a reduction in income which results into reduced spending and aggregate demand, this means that an increase spending by government on infrastructure will provide employment, increased employment will ensure that individuals have income to spend and the increase in spending will encourage further investments. Therefore the government has a role to play in improving the economy in a recession. reduced the solution to a depression is increased government spending in investment which will result into an increase spending in the economy increasing output and reduced unemployment in the economy. Interest rates: On monetary policies Keynes (2007) states that an economy should reduce interest rates, given that interest rate is the cost of borrowed capital the reduction of interest rate will encourage investment, increased investment will result into an increase in employment, and this effect is summarized below: The above diagram summarizes Keynes theory on the role of investment in the economy, it is evident that if interest rates are reduced then there will be increased investment, an increase in investment means that there will be an increase in employment, the increase in employment means that more individuals in the economy will have income to spend and the higher the income the higher the spending, higher spending will stimulate investment whereby investors will anticipate an increase in demand, the increase in investment that leads to increased spending is referred to as the multiplier effect. Taxation: Fiscal policies such as taxation have a role to play in Keynes theory, an increase in taxation in each stage above will reduce consumer spending, and therefore a reduction in taxation in the above case will lead to an increase in spending and therefore in a recession a reduction in taxation improve spending. According to Stein (1992) Classical economists advocated for a market economy where government intervention only made situations even worse, they state that the economy should be left to the automatic equilibrium mechanism which they referred to as the invisible hand, this was the policy measure followed in the 1930's which was a total failure of policy makers to improve the situation, they argue that the economy will undergo recessions but in the long run the economy will automatically adjust. Friedman (2007) state that the 1930 depression was caused by poor monetary policy measures, in 1929 to 1933 there was a reduction in money supply and the monetary policy makers did not take action, banks collapsed but no actions were undertaken and this led to the depression, according to Friedman therefore government intervention in times of crisis is necessary to improve the problem, he states that small banks would not have collapsed if actions were taken early, therefore it is important for a government intervene to rectify a recession. The advantages of government intervention during the 1930's depression is evident whereby some countries that implemented policy measures to improve the situation were less affected, example Japan was not hard hit due to the government spending, Japan increased spending and monetary policies were used to reduce inflationary pressure, however deficit spending affected the economy in 1934 but a reduction in spending and price controls. From the above discussion it is evident that the government has a role to play in the improvement of an economy under a recession, these measures however have other adverse effects but it is appropriate for government intervention to prevent a crisis like the one experienced in the 1930's. Countries in the world today are experiencing a recession and policy makers have taken action by reducing interest rates to increase investment and customer spending in the economy, one example is the bail out in the US and a reduction in interest in many economies all over the world. Spending will be stimulated by increasing consumer income, income will be increased in an economy by increasing employment, this is evident from government policy to increase investment by reducing interest rates which will provide more employment opportunities, the government will also increase spending on investment where more job opportunities will be provided. Also the government will reduce taxes on investment, goods and services in order to stimulate spending although this is considered as an inefficient method to stimulate aggregate demand. Conclusion: From the above discussion it is evident that the government should intervene in times of crisis such as recession, this is appropriate in order to avoid further damage in the economy such as a depression which follows a recession, appropriate policy measure should be implemented to avoid other effects such as inflation. From the above discussion Keynes advocate a reduction in interest rates to increase investment that will provide employment, increased employment means people will have more income to spend and an increase in spending will encourage more investment. The government should also increase spending on infrastructure which will provide employment increasing spending and the other measure is to reduce taxation although this is less effective in stimulating spending. Comparing countries that implemented policies in the great depression show that some countries such as Japan applied expansionary fiscal policies, compared to other countries Japan was not strongly affected because the government applied government spending during this period and reduced inflationary pressure by reducing spending after the depression, therefore we conclude that government intervention is important in times of crisis. References: Carlos Marichal (1989) Century of Debt Crises in Latin America: From Independence to the Great Depression, Princeton University Press, Douglas Fisher (1990) Monetary and Fiscal Policy, New York: New York University Press. Jerome Stein (1992). Monetarist Keynesian and classical economics, Oxford: Blackwell publishers Maynard Keynes (2007). The General Theory of Employment Interest and Money, Hampshire: Macmillan press. Milton Friedman and Rose Friedman (2002) Capitalism and Freedom, Chicago: University of Chicago Press. Read More