The economic growth of a nation is very much dependent on the rate of employment, investment, interest rates, and other macroeconomic tools. However, for it to be sustainable, different policies are employed to ensure that the rate of inflation and unemployment are minimal as the GDP growth rate increases at a rate of 3% annually. The fiscal and the monetary policies are the two major tools that are employed to ensure that the above conditions are maintained.
The essay looks into a scenario whereby the rate of unemployment has been too high, inflation at 2%, GDP growth rate at less than 2% annually, and with interest rates almost zero. It explains how both monetary and fiscal policies can be applied to alter the situation holding inflation rate constant. Any positive and negative effects as a result of the undertakings are also included. Lastly, it addresses the dangers associated with a growing budget deficit as a result of high debt and the consequences this may have on the policy changes made.
The U.S operates in both a closed and open economies as it exports and imports and allows business transactions to take place at the domestic market. Therefore, manipulation of the monetary policy will affect both domestic financial transactions as well as international trade partners (Federal Reserve Bank of San Francisco, 2004).
With the high employment rate, it implies that the GDP growth rate will be low as demonstrated by the Okhun’s law. The law states that the rate of high unemployment is not the only factor that leads to low GDP growth rate but other associated factors (Snowdon & Vane, 2003).
The first move would be to get reasonable estimates of the anticipated economic changes. It would be imperative to determine the level of government spending, taxing policies, international operations, domestic and abroad financial conditions, and technological application aimed at the boost of production rate. With these developments, then an economic model would be developed that incorporates partial if not all of the developments.
The next move would be aimed at reducing government spending through an increase on the rate of taxation. This would be based on the concept of multiplier effect as a result of taxation. Multiplier effect is just the change resulting from autonomous spending which leads to increase in income (Byrns, 2011). On the other hand, the tax multiplier application ensures that the aggregate spending of the government is reduced through increase in taxes (Byrns, 2011).
This is part of the fiscal policy that would be applied to increase income and lower spending through increased taxation with the aim of boosting the GDP. Although the model would ensure that GDP growth rate is increased as a result of increase in disposable income, taxation reduces the rate of borrowing which may halt investment in the short run (Byrns, 2011).
According to the Philip’s curve, there exists a relationship between inflation and the rate of unemployment (Delong, 1998). The two macroeconomic indicators are mutually interdependent for example; when one is high the other is low. This makes it hard to maintain inflation at a low rate at the same time when the unemployment rate is low. Basically, the anticipated rate of inflation is applied to maintain a low rate of inflation.
Figure1: Philip’s curve
Source: Delong (1998)
Through the application of monetary policy, the interest rates can either be increased or reduced (The Federal Reserve Bank of San Francisco, 2011). In the case scenario, any further reduction would see investors borrowing more funds and investing in the U.S domestic economy.
This would create employment and reduce inflation (Stone, 2012). The purchasing power of the employees will also increase as they would have adequate disposable income which can be used to purchase. According to the Okun’s law when the level of unemployment is reduced by a certain percentage, the GDP is also expected to increase at the same percentage and vice versa (Snowdon & Vane, 2003).
So, low interest rates increase the rate of investment which creates employment thus lowering unemployment rate and increasing the GDP growth rate. However, low interest rates are bad for an economy as they deter depositors from investing their money. During this period of business cycle, the Fed is required to increase the interest rates to more that the current level. This will reduce the rate of spending as well as the borrowing levels but the depositors will start depositing more to replace the deficit in the financial institutions.
Because of the high interest rates, foreign investors will reduce their rates of borrowing and spending. Most definitely, the investment levels will be reduced. Low investment leads to high rate of unemployment thus low inflation (Federal Reserve Bank of San Francisco, 2004). However, the prior investments will increase production thus an increase in GDP while the rate of unemployment remains constant.
This is better explained by Okun’s law that stipulate that unemployment is not the only factor that lead to low GDP levels (Snowdon & Vane, 2003). For example, increase in labour force and production (holding the anticipated natural unemployment level constant) would result in real income becomes high and so is spending. Given that the interest rates are almost zero, then they cannot be lowered any further as there is no adequate room to stimulate the economy (Federal Reserve Bank of San Francisco, 2004).
What can be applied are the unconventional methods like having the interest rates high in the long run? Reducing the interest rates further exposes the economy to deflation risk which affects the economic growth rate. This is the worst business phase in the business cycle as it may to lead to depression (Federal Reserve Bank of San Francisco, 2004).
Upon cutting the spending through taxation and increasing interest rates, it would be imperative to allow open market operations. The Fed would use this tool to influence the supply availed in the banking reserves (The Federal Reserve Bank of San Francisco, 2011). The fed would sell the extra government securities with the aim of adjusting the amount of money supply as well as the demand (The Federal Reserve Bank of San Francisco, 2011).
This would adjust inflation issues upon the open market operations. Later, as the GDP rate starts to rise, the Fed can start buying government securities in the open market so as to keep the banking system stable (The Federal Reserve Bank of San Francisco, 2011).
The use of the monetary policy to stimulate the economy should be at minimal. According to the Federal Reserve Bank of San Francisco (2004), if the stimulation impacts aggregate demand to extent of pushing capital and labour markets beyond their limits, prices and wages are increased at a fast rate. So, the Fed cannot use the monetary policy to maintain low ‘real interest rates’ in the short run.
The consequence would be increased inflation characterized by unstable unemployment rates and GDP growth rates. Although there exists a tradeoff between lower unemployment and high inflation in short run, which is not applicable in long run. Therefore, monetary policy has adverse effects when used to stimulate the economy.
For example, if people anticipate the expected inflation to rise in future, prices and wages are expected to increase thus raising inflation further (Federal Reserve Bank of San Francisco (2004). This is followed by insignificant changes in the rate of high unemployment and the ultimate growth rate.
Part 2: The dangers of a high debt to GDP ratio and a growing budget deficit
When the ‘high debt to GDP ratio’ is high, the federal government finds it hard to continue the sale of government securities in the open trading markets (Cashell, 2010). This prevents the Fed from controlling the rate of inflation and unemployment rates (Checherita & Rother, 2010).
The rate of unemployment is deemed to increase as no foreign investor would be willing to invest in a nation that has a declining economic growth rate. With the low investment rate, the growth rate and the level of production would decrease (Latter, 2012). Persistent increase in the budget deficit would in the short run affect the economic output of a nation (Cashell, 2010; Latter, 2012).
However, this can be stimulated by the Fed through increase in the interest rates to curb external and internal borrowing. Debts and budget deficit usually arises from the export and import markets. When a nation imports more than it exports in a continuous time frame, the balance of payment is affected hence budget deficit. The effect would see a significant drop in demand for U.S goods and services in the foreign market.
With a high domestic borrowing to sustain the budget, capital inflows are more likely to increase which reduces investment hence the increase in credit demand at the domestic level (Cashell, 2010). Private business may find it hard to borrow finances from credit markets to sustain their growth. If the firms are losing money in an economy that cannot sustain itself, then no lender would be willing to risk their finances.
The ‘high debt to GDP ratio and a growing budget deficit’ would definitely affect the measure of selling the government securities. In this case, the Fed would be required to buy more government securities from the commercial banks (Cashell, 2010).
This is because no foreign or private buyer would be willing to buy securities which have low value in the international market. This would increase the Fed’s reserve stock while those of commercial banks reduce. The increase in Fed reserves increase its lending capacity to the commercial banks hence increases in demand deposits.
The amount of money in circulation would increase reducing the rate of inflation in short run but leading to high inflation if the trend continues (Cashell, 2010). So the Fed which has its independence may not allow inflation to countercheck the high debt rate. Instead other models of economic stimulation should be used like bargaining for debt relief from international donors to ensure sustenance at domestic level.
To sum, it up, the monetary policy and the fiscal policy are applied with care while stimulating economy since they are based on estimations. Continued application could lead to deflation which may cause depression. The major moves in the case scenario would be analyzing the situation, reducing spending through taxation, increasing interest rates with the aim of stimulating economy in the short run and avoiding the consequences associated with it in the long run.
Byrns, R. (2011). The mathematics of simple Keynesian multipliers. Retrieved from http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/K_Mult_EQs.htm
Cashell. B. W. (2010). The Federal government debt: Its size and economic significance. Congressional Research Service. Retrieved from http://www.fas.org/sgp/crs/misc/RL31590.pdf
Checherita, C., & Rother, P. (2010). The impact of high and growing government debt on economic growth an empirical investigation for the euro area. Working Paper Series, NO 1237 / AUGUST 2010
DeLong, J.B. (1998). The Phillip’s curve. Retrieved from http://econ161.berkeley.edu/multimedia/pcurve1.html
Federal Reserve Bank of San Francisco (2004). U.S Monetary policy: An introduction. Retrieved from http://www.frbsf.org/publications/federalreserve/monetary/MonetaryPolicy.pdf
Latter, S. (2012). The U.S. National Debt: How Bad is the Problem? Retrieved from: http://welkerswikinomics.com/blog/2011/02/22/the-u-s-national-debt-how-bad-is-the-problem/
Snowdon, B., & Vane, H. R. (2003). An encyclopedia of macroeconomics. Cheltenham, UK: Edward Elgar.
Stone, C. (2012). CBPP Statement: February 3, 2012. Center on Budget and Policy Priorities. Retrieved from http://www.cbpp.org/cms/index.cfm?fa=view&id=3670
The Federal Reserve Bank of San Francisco. (2011). What are the tools of U.S. monetary policy? Retrieved from http://www.frbsf.org/publications/federalreserve/monetary/tools.html