Market Economies, Deflationary Gaps, and Monetary Policy - Assignment Example

Question Why do market economies need Government? Illustrate graphically and comment critically upon the trends in the United Kingdom’s Economic growth, Inflation and Unemployment over the past (approximately) ten years. Need of Government for Market Economies Market economies need governments for a number of key reasons: i) Governments can keep track on formation of monopolistic or oligopolistic powers in a market economy. Monopolistic and oligopolistic structures can form within a market economy and lead to dominance of some suppliers in their respective markets. Such situations create disadvantages of buyers and reduce buyer surplus for those particular markets. For this reason, free market economy can potentially impinge on the rights of a certain segment in the economy (Acemoglu, Golosov and Tsyvinski, 2008). A fair exchange implies a relationship of equality between the persons concerned, which is absent in these scenarios. Sometimes, in a market economy the employer and the employee are not in a relationship of equality. The employer can attempt to dictate terms to the employees, therefore, a safeguarding body is required to ensure payment of minimum wages and to enforce health & safety measures (Agarwal, 2007). Government presence in needed in such situation to ensure rights of certain groups is not compromised. ii) Governments are needed to provide provision of pubic goods whose benefits are distributed over a very large population. For instance, creation of roads and national defense cannot be provided by a private enterprise. Government interventions are needed in the market economic system for these provisions (Halm, 2003). iii) Governments are also needed in market economic systems to provide social security to the citizens of the country. A market economic system cannot find mechanism to transfer funds from rich to poor. Governments serve the purpose of reducing income differences between rich and poor in an economy (Sharma, 2009). Government invention is, therefore, essential for redistribution of wealth and income for a healthy society. United Kingdom’s Economic Performance During Last Ten Years Growth Performance data of United Kingdom’s economy is graphed below. The data exhibits that the economic performance and growth rate of United Kingdom’s economy was at peak in the year 2000. The growth rate of the economy was highest which implies that the standard of living of UK citizens was increasing at a very rapid pace. GROWTH PERFORMANCE Year GDP Change 2000 3.90% 2001 2.50% 2002 2.10% 2003 2.80% 2004 3.00% 2005 2.20% 2006 2.90% 2007 2.60% 2008 0.60% 2009 −4.9% 2010 2.10% 2011 0.70% Growth of UK’s economy hit the bottom in the year 2009. It appeared that the economy is on the path of improvement in the year 2010; however, growth figures were low again for the year 2011. Growth Performance the annual inflation figures of UK economy shows that inflation is rising even though growth rate of the economy is slow. Such figures are considered alarming because standard of living of people is compromised in two manners – through low income growth, at the same time, a considerably high level of inflation (Baumol and Blinder, 2011). Annual Inflation Year Inflation Rate 2000 2.1% 2001 2.7% 2002 1.3% 2003 2.9% 2004 2.6% 2005 3.2% 2006 2.4% 2007 4.2% 2008 4.1% 2009 0.1% 2010 3.7% 2011 5.1% Unemployment Rate of UK’s economy is exhibiting a trend of rising with the inflation rate of the economy. This is considered one of the most challenging macroeconomic situations in macroeconomic text books. This is because a high inflation is generally associated with lower levels of unemployment since all factors of productions are considered to be highly utilized. Rising unemployment with inflation indicates major issues with the economy which need to be resolved (Henderson, 2003). Unemployment Rate Year Rate 2001 5.1% 2002 5.2% 2003 5.0% 2004 4.8% 2005 4.8% 2006 5.4% 2007 5.4% 2008 5.6% 2009 7.5% 2010 7.9% Deflationary Gaps and Appropriate Policy Responses Deflationary gap in an economy is the difference between the potential performance of the economy – in terms of total value of goods and services produced - and its actual performance. This gap shows the level of improvement which can be attained within an economy through appropriate policy response. Price Level SRAS Deflationary Gap AD Real GDP Appropriate policy responses to deal with deflationary gaps comprises of increasing discretionary government expenditure for the economy (Laxton, NDiaye and Pesenti, 2006). Also, reducing taxes on businesses and subsidization of certain industries can serve to reduce deflationary gaps and increase Gross Domestic Product of the economy (Grossman, 2005). Question 2 – Explain the objectives of monetary policy and the mechanism through which Monetary Policy operates to control inflation.  Monetary Policy Monetary policy refers to the use of corrective actions by the monetary authority of the country – usually the central bank – to fulfill its objective of macroeconomic stability by using money supply. Monetary policy strives to achieve the various objectives of economic policy, which include economic growth , achieving full employment and managing external balance. Monetary policy is known as collective use of tools by central bank to achieve predefined goals. Monetary policy differs from fiscal policy (Baurnol, 2011). These two policies interact and together form the policy mix . The Objectives Of Monetary Policy According to modern economic theory, the objectives of monetary policy is to maximize economic welfare of households. This is generally attributed to two main objectives of monetary policy - price stabilization and stimulation of economic activity. These two objectives are closely linked. Price stability is a prerequisite to sustained economic activity. However, if some economists posit that there is no arbitrage between long-term price stability and economic activity because money is neutral in the long term (Adil, 2006). Therefore, according to this school of thought, the only long-term objective of the central bank should be maintaining price stability. In this case the level of growth potential depends on multiple factors – for instance, productivity, capital stock, etc. – on which monetary policy has no impact. The ultimate objectives  of monetary policy, as agreed by majority of economists is – price stability or nominal GDP. Monetary policy cannot directly address these objectives because central banks only have very indirect control of these economic variables, which react with long and variable lags and are observed with a long delay and an infrequent spaced. For this reason, intermediate objectives of monetary policy – such as aggregates or currency exchange rates – are established. These interim targets have no value in themselves (Acemoglu, Golosov and Tsyvinski, 2008). These secondary goals of monetary policy are more controllable and more quickly observed than the ultimate goals. Tools Used By Monetary Policy To Achieve Its Objectives There are a number of tools used by monetary policy to attain its objectives. These tools comprises of variables that are directly under the control of the central bank. The choice of instruments and the rules defined for manipulating these variable determine monetary policy on a daily basis. There are two main policy tools for the central bank: The action on bank liquidity, whereby the central bank acts on second-tier banks by supplying more or less money, and by altering the rate of reserve requirements (Henderson, 2003). The action on interest rates. The central bank plays on three key interest rates it controls – the rate of the marginal lending facility, the deposit facility rate and open market operations (Grossman, 2005). Changes in these rates affect the behavior of second-tier banks. Most central banks choose the interest rate as an instrument in the short term. This is the only rate a central bank can effectively control precisely. Indeed, the assets of the very short term are very close to the money liquidity, and the central bank has a monopoly on issuing money (Gupta, 2001). By controlling interest rates in the short term, the central bank has a strong influence on the supply of liquidity. However, as and as maturity increases, rates incorporate market expectations and thus outside the control of the central bank. Monetary policy can aim to maintain the exchange rate of currency with a national currency or a basket of currencies. The fixed exchange rate can be obtained by the central bank by selling or buying currencies on a daily basis to achieve the target rate. Somehow, the central bank gives up its independent monetary policy, which is subjected to the triangle of incompatibility (Adil, 2006). The central bank maintains a unit of the anchor currency for each unit of currency in circulation: it does not have any latitude to pursue a policy tailored to the national economy. This solution allows to "import" the credibility of the foreign currency: the currency board are often implemented as a result of episodes of hyperinflation (Acemoglu, Golosov and Tsyvinski, 2008).  Following the development of monetarism in the 1970s, some countries have adopted a monetary policy based on targeting of monetary aggregates. The money supply in a monetarist perspective must grow at the same rate as the national product (Baumol and Blinder, 2011). If the money supply is under control, inflation will remain stable. This policy was adopted by Paul Volcker in the United States early in his term, and then was quickly dropped. Today it is rarely implemented: indeed, it involves mechanically highly volatile interest rates. The inflation targeting is a policy to keep inflation close to a goal. The central bank can set a numerical target (eg 2%), a zone of indifference (eg between 1% and 3%) or a target surrounded by a margin of fluctuation (eg 2% to ± 1 %). According to the proponents of this strategy, inflation targeting has several advantages (Agarwal, 2007). References Acemoglu, D., Golosov, M. and Tsyvinski, A. (2008) Markets versus governments, Journal of Monetary Economics, vol. 55, no. 1, pp. 159-189. Adil, J. (2006) Supply and Demand, Minnesota: Campstone Press. Agarwal, V. (2007) Macroeconomics, New Dehli: Tata-McGraw Hill. Baumol, W. and Blinder, A. (2011) Economics: Principles and Policy, Ohio: Engage Learning. Baurnol, W. (2011) Macroeconomics: Principles and Policy, Ohio: Engage Learning. Fisher, B. (2007) The Supply and Demand Paradox: A Treatise on Economics, South Carolina: Booksurge LLC. Grossman, G. (2005) Economic systems, Ohio: Prentice Hall. Gupta, G. (2001) Macroeconomics: theory and applications, Ohio: Mc-Graw Hill. Hall, R. and Lieberman, M. (2008) Macroeconomics: Principles and Applications, Ohio: Engage Learning. Halm, G. (2003) Economic systems: a comparative analysis, New Jersey: Holt, Rinehart and Winston. Henderson, H. (2003) Supply And Demand, New Jersey: Pearson Education. Laxton, D., NDiaye, P. and Pesenti, P. (2006) Deflationary shocks and monetary rules: An open-economy scenario analysis , Journal of the Japanese and International Economies, vol. 20, no. 4, pp. 665-698. Strauss, H. (2004) Demand and supply of aggregate exports of goods and services, Berlin: Springer-Verlag. Temple, P. and Williams, G. (2002) Infra-technology and economic performance: evidence from the United Kingdom measurement infrastructure, Information Economics and Policy, vol. 14, no. 4, pp. 435-452. Read More