The economy today - Essay Example

1 If business cycles were really inevitable, what purpose would macro policy serve The business cycle phenomenon is defined as the recurrent fluctuations of output about trend and the co-movements among other aggregate time series (Lucas 1977, p. 9). Fluctuations are by definition deviations from some slowly varying path. Since this slowly varying path increases over time, it is proper to adopt the common practice of labeling it as a trend. This trend is neither a measure nor an estimate of the unconditional mean of some stochastic process. Rather, it is defined by the computational procedure used to fit the smooth curve through the data. There are various possible reasons for these apparent short-run fluctuations. One explanation is that there are two independent processes acting on the economy: a long-run process described by the Solow model that determines the rate of growth of GNP; and a separate short-run process that causes temporary short-run fluctuations over several quarters or years. Milton Friedman had said inflation was just a monetary phenomenon and macro policy couldn't shift the economy to higher levels of employment. The impact from macro policy debates starts the macro section with a treatment of long-run growth as a function of supply side productivity factors. It is then followed, though, by the old standard aggregate demand and supply analysis that emerged in the late 1970s. The question and subject matter of long-term growth is really distinct from that of short-term business cycle analysis. It is believed that a major reason that the patterns of economic activity predicted by the initial political business cycle models have not been so clearly visible is that these initial models were based on too simple views of the objectives of governments (Hirsch & De Marchi, 1990). Thus, it is by thinking positively that business cycles can be shrunk in order to make economic trends become a little more predictable. Macro policies serve as leverage in times of recessions to assist the government in maintaining stabilization. 2.) If deficit spending "crowds out" some private investment, could future generation be worse off If external financing eliminates crowding out, are future generations thereby protected In a closed economy, if the government raises its budget deficit in the short run, both prices and GDP will rise. In the new equilibrium the real income is unchanged but the nominal is higher. The demand for money, then, increases. This means that with a fixed money supply the interest rate will rise so reducing the investment. Thus, the new equilibrium has lower investment demand and lower national savings. This is known as the crowding-out effect. In the case of a large recessionary gap the crowding out effect is much less important because with the rise of GDP determined by the government the volume of private savings will increase and will finance the deficit. By reducing private investment, the crowding out effect implies that the stock of capital to pass on to the future generation will be smaller and smaller will be the output as well. This is the long-term burden of the debt. If government spending crowds out private investment and reduces the wealth of a country, deficits are not eliminated or reduced because of short term stabilization policy that reduces the deficit involving real costs today, in higher taxes and lower government services, in exchange for benefits in the future. Such exchange does not appeal to everyone. However, there is little evidence to back up the idea of government borrowing "crowds out" private borrowing and thus reduces private investment and increases interest rates. This has not been the effect in Japan, and cannot be shown to be the effect of deficits in the United States. Private savings and investment are reduced by government expenditures--regardless of whether they are financed by government borrowing or by taxation. Either way the private individual is left with less money, and ultimately with fewer resources. The attempt to replace borrowing with taxation makes sense only if it leads to a reduction in government expenditures. 3.) Why do banks want to maintain as little excess reserves as possible Under what circumstances might banks want to hold excess reserves While all bank must have excess reserves to incur the new liabilities which result from making loans, all the reserves are not loaned out. Remember that banks create new demand deposits when they make loans, they do not lend reserves. There is an instance when they use reserves, this is to purchase a government security bonds. The Federal Reserve Bank (FRB) requires banks to have reserves because this also allows the facilitation of collection and clearing of checks. Reserves are assets for banks because banks can easily use this money for loans or purchases. Reserves are assets for banks because they are kept on deposit with the FRB or as vault cash. The banks can freely use that money for loans or purchases because they basically own that capital as an asset. However, reserves are a claim against the commercial banks in the Federal Reserve Bank and FRB deems those as a liabilities. "Excess reserves" is the amount of money the bank has when actual reserves exceeds its required reserves. Banks make money through lending money. From an economic standpoint the purpose of the reserve requirement which divides actual reserves into required and excess in the way you all describe, is to limit bank lending. Banks cannot make new loans without excess reserves. If they did, there would be no backing for these loans. Thus, to earn in the banking business, banks must maintain as little excess reserves as possible. As they use more excess reserves by loaning these to others, more income will turn over by using that money. Thus, the more excess reserves loaned out, the bigger their profits will be. 4.) Look at the summary of the Tax Relief Act of 2001 at www.whitehouse.gov/infocus/tax-relief. What was the purpose of the tax cut Was the tax policy designed to be a countercyclical fiscal policy President Bush's 2001 Tax Relief Act aimed to "give the economy a timely second wind by placing more money in the hands of consumers and entrepreneurs." President Bush believed that in the long run, "wealth is created by hard-working, risk-taking individuals, not government programs." The Tax Relief Act of 2001 enacted substantial reductions in personal and estate tax rates, which were forecasted to reduce revenues by around 10 trillion dollars over ten years. The Tax Act reduced the income tax rate applied to income in the lowest income tax bracket from 15 percent to 10 percent, with this change applied retroactively to income earned from the start of 2001. The tax rebates represented an advance payment of this tax cut. The first income tax bracket applied to the first $6,000 of income for a single individual filing a return, and to the first $12,000 of income for a married couple filing jointly, so that, of the approximately two-thirds of U.S. households that received a rebate, most received rebates of $300 or $600. The Internal Revenue Service determined the rebate amounts for each tax filer based on his or her year 2000 tax return. While the 2001 tax rebates stimulated consumer spending, without knowing the full structural model underlying these results, Johnson, Parker & Souleles (2004) concluded that future tax rebates will have quantitatively the same effect. Thus, the rebates in 2001 were part of countercyclical stabilization policy. The spending response to other tax rebates may differ across time and circumstances. For instance, the response might be smaller outside of a recession or given a different situation for household balance sheets and liquidity. The task of countercyclical monetary policy may be described as trying to keep real GDP near potential GDP, when inflation is on target. Of course, with the impacts of a change in monetary policy occurring with long and variable lags, the central bank might not be able to get aggregate demand back to potential GDP fast enough to prevent the incipient inflation from becoming an actuality. References Hirsch, A. & De Marchi, N. (1990). Milton Friedman: Economics in Theory and Practice, New York: Harvester Wheatsheaf. Johnson, D.S., Parker, J.A. & Souleles, N.S. (2004, September). Household Expenditure and the Income Tax Rebates of 2001. NBER Working Paper 10784. Lucas, R.E. Jr. (1977). Understanding Business Cycles, in Karl Brunner and Allan H. Meltzer (eds), Stabilization of the Domestic and International Economy, Carnegie-Rochester Conference Series on Public Policy, 5. Solow, R.M. (1956), "'A Contribution to the Theory of Economic Growth'", Quarterly Journal of Economics, 70, February. The President's Agenda for Tax Relief. The Whitehouse Website. Acquired online last November 29, 2005 at http://www.whitehouse.gov/news/reports/taxplan.html Read More