The Macro-Economic Effects of Fiscal Policy - Assignment Example

Macro & Micro Economics Question Scholars have provided a broad range of definitions for recession. Recession is defined byClaessens and Kose (2009) as a significant decline in economic activities, normally visible in real income, employment, production among other indicators. This decline in economic activity spread across the country’s economy. According to Beaudry, Galizia and Portier (2014), recession occurs after period of rapid accumulation of business capital, consumer durables and accumulation of houses. In particular, Hayek is of the opinion that of recession in most cases mirrors periods of liquidation emanating from past over-accumulation of capital goods. However, Keynes provides a different definition of recession. In Keynes’s perspective, recessions reflects periods of deficient cumulative demand (Beaudry et al. 2014). The process of establishing whether a given country is in recession takes time. According to Claessens and Kose (2009, p. 52) this process revolves around looking at a broad range of economic variables such as industrial production, sales, income and employment, and GDP. One way of determining whether a country is in recession is by looking at the country’s Gross Domestic Product (GDP). Khan and Calver (2014) define GDP as the market value of all final services and goods generated in a country’s in a given time. During recession, there is a general decline of GDP. Brewer et al. (2013, p. 182) argue that, in order to evaluate the effect of recession in a given country, three pieces of analyses are performed. These analyses include analyzing actual micro-data on the household distribution within a given period, now casting the household income distribution within a given period as well as projecting the household income distribution within a given period. During Britain’s recent recession, household income and unemployment was found to have increased while there was a general decline of GDP. Khan and Calver (2014) is of the opinion that GDP is reported quarterly and as such, it cannot be utilized to determine whether a country is in recession or not. The different between the final GDP estimates and the initial GDP estimate can be quite large. There is also need to define GDP using the household dimension. The basic tenet of relying on this definition is that legal institutions do not actually experience well-being but people do. As argued out by Khan and Calver (2014, p. 2), economists should place much emphasis on what is happening to households during the recession period. Critics of GDP are of the opinion that GDP fails to encompass important services and goods simply because they do not trade in markets. Some of these services include those provided by mothers and wives within the household such as house-cleaning, food preparations, caring for the elderly and the sick as well as child rearing (Dorman 2014, P. 68). In particular, GDP fails to encompass the underground economy whose transactions are not brought to attention to government agencies that compiles the country’s GDP. Question 2 Over years now, Britain has been one of the countries adversely affected by the economic recession. The economic recession in Britain has had and continues to exert adverse effects on a wide range of ways. The early 1980s and 1990s economic recessions were linked with big falls in employment among the older workers. Firms found it appropriate to get rid of older workers through early retirements. The IFS research opines that this fear of unemployment is well founded because normally unemployment is less volatile for 18 to 24 years workers (Simpson 2009). The unemployment rate of the 18-24 aged workers grew at a rapid rate over the period of 2008. By October 2008, the unemployment rate of this age group had grown beyond 2.5 percent, a rate that was extremely higher than the same month in the previous year. In terms of numbers, the figure of the unemployed workers between the ages of 18-24 was as high as 726,000 and with those out of work force more than a period of one year reaching 528,000, a figure that had never been witnessed in the country. This fear of escalating unemployment levels continues to grow as the danger of the young people is in the line. The economic recession is also attributed to adverse impacts on the living standards of people. Studies carried out by the IFS have examined how the previous three recessions of 1970s, 1880s, and 1990s have impacted on the living standards, inequality and poverty as well as other adverse impacts on the different groups in the society (Hills,Thomas, & Dimsdale 2010). Families that mainly depended on the wages and salaries had their living standards adversely affected by the economic recessions than those families dependent on state benefits or fixed incomes. Over these periods of recessions, the levels of inequality rose up and remained so until the present times. Precisely, recession can push relative poverty either upwards or downwards. With rises in the levels of unemployment, the number of lower income households will be expected to go higher (Vaitilingam n.d). In practical terms, relative poverty across the entire population has fallen over this period of recessions. Studies on the impacts of recession have shown that it has adverse effects on the happiness and mental health of people. Roberts (2015) asserts that one fifth of the decline in the levels of happiness in people is a result of losing jobs or remaining unemployed for long periods. Roberts (2015) further argues out that unemployment decreases the life satisfaction in people even when they are back working. The construction sector in particular has been one of the worst affected, with figures show that the construction output has fell by 5% in 2008, and 2.2% in 2009. In terms of job losses, the manufacturing industry suffered the most in the first quarter of the year 2009, with employment levels falling by 78,000-2.94 million. In terms of output, figures for the GDP in the initial quarter indicate the production industry falling by 5.1% and the service industry by 1.6 %. (Hills, Thomas, & Dimsdale 2010). Fiscal policy is the utilization of government spending and taxation to influence the country’s economy. Typically, governments utilize fiscal policy to promote a sustainable growth and reduce poverty. In the current economic recession, the role and objective of fiscal tools has gained much prominence and are widely utilized to get the economy of countries back to normal (Afonso & Sousa 2009). Alternatively, instance, the government can spend more, cut on taxes, or perhaps do both things. The British government can effectively utilize the fiscal policy tools to avoid or mitigate the negative effects of recession. For short-term and long-term solutions, the concept of Keynes can be applied in the UK to get the country of the adverse effects of recession. Keynes’ are of the view that economies should embrace the idea of fiscal stimulus and deficits when faced with the challenges of recession (Carling 2012). Various governments have in the past used the idea of fiscal stimulus to get their economies out of the recession. Much the same way, the British government can also apply this policy to kick-start its income in times of recessions. The notable example from which the British government should borrow is how the Australian government embraced the theory of Keynesianism to redeem its economic profile in the early 1970s. The Australian government held an opinion that this Keynesian principle would strengthen the productive capacity of the economy. The UK is on record for also embracing the principle of fiscal stimulus to get the economy of the country back on track. On 24th November 2008, the British government announced a temporary “fiscal stimulus’ to mitigate the effects of recession. According to the proponents of fiscal stimulus, the effects of recession are equally felt in all other parts of the economy. To mitigate these effects, the British government in particular opted for immediate reduction in indirect taxes in the face of the 2008 recession. Alternatively, the British government can find the Hayek’s worldview beneficial to putting short-term and long-terms measures to the effects of recession. Hayek principle is based on embracing the ultra-easy monetary policy. According to Hayek, his idea is more associated with the idea of economic freedom (Miller 2013). He asserted that the best thing governments can do to enhance freedom and prosperity is to provide a stable and predictable framework of regulation and policy under the rule of law, with limited government, stable and low tax rates, and sustainable public finances. Hayek is in favour of a fiscal consolidation in the current environment, combined with expenditure and tax reform and other structural policies to strengthen the long-run growth potential economy. The Hayek principle can be applied to solve the recession mess in the Britain in the following ways. The recovery process in Britain requires assets, which have been misapplied during the boom to be reshuffled into a new pattern. These resources ought to be moved to create a sustainable accord with actual saving decisions and risk preferences (Miller 2013). Additionally, the Hayek principle is concerned with the assertion that banks are the cause of economic instability and they hugely affects boom. Because of this fact about the banks and economy, the British government should focus on the reform of the banking system as a way of reducing large-scale economic instability. Specifically, the British government can mitigate the effects of economic recession by regulating banks. The central bank should in particular have the discretion on what to do. In theoretical terms, it is clear what the policy in Britain should look like. When economic conditions are not good and growth is, weak the government should reduce interest rates, and then increase these rates when economic boom starts to come back. In the UK, the 2008 recession was inexplicable and unforeseeable. The UK government played an integral role in encouraging recession. In particular, UK government failed to effectively regulate financial market and giving implicit guarantees to financial institutions and other borrowers (Brewer et al. 2013). In particular, the UK government decided to bail out some financial institutions as a way of recovering from recession. According to Hayek rule, authorities should play an integral role in counteracting a decline in overall spending. To deal with recession, the Bank of England and the Fed agreed to minimize short-term interest rate and inject their money markets with liquidity. However, low interest discouraged savings. The UK government also provided a temporal fiscal stimulus aimed at assisting struggling financial institutions to recover. In order to boost expenditure, the UK government reduced its standard Value Added Tax (VAT) by 2.5% (Devereux & Fuest 2008). Hayek was absorbed and fascinated by the role that prices play in navigating decisions and resources. Hayek’s opinion is that low interest rates have the potential to encourage a myriad of investments such as home buildings that can turn out to be counterproductive when the interest rates will finally go higher (Roberts 2010, p. 4). Hayek’s perspective was that the government should let the economy heal by itself as opposed of trying to do something. In particular, Hayek does not advocate the idea of providing temporal fiscal stimulus to financial institutions. He was more worried about inflation and deficits that might follow authorities spend excessive money during recession. Keynes further posits that adjustment will take a considerable long time and will take place unpredictably with a myriad of delays. If Hayek was alive today, he would have argued out that the UK housing market should be left to heal by itself and the UK government should stop lowering the interest rates or injecting money into the economy (Roberts 2010, p. 5). Keynes, on the other hand disputed the idea of high inflation and high unemployment by arguing that it is impossible for this to happen. However, it happened and Keynes and his supporters found themselves on the defensive. Figure 1: Quarterly versus annual fiscal data, U.K (Afonso & Sousa 2009). Conclusively, it is evident from this essay that economists use various indicators to establish whether a country is in recession or not. Some of the economic variables analyzed include industrial production, sales, income and employment, and GDP. During recession, there is a general decline in GDP and an increase in the unemployment rate. In Great Britain, the 2008 recession was marked by an increase in the unemployment rate and a decline in country’s GDP. Scholars have established a myriad of problems associated with the use of GDP to determine a country’s economic well being. Some of the concerns raised include GDP does not include all important services and goodsBesides, GDP does not include the depletion of natural resources. As part of responding to the 2008 recession, the UK government announced a broad range of measures. Some of these measures include providing temporal fiscal stimulus and injecting taxpayers’ money into UK financial institutions. In Hayek’s opinion, a country should do nothing during recession and should let recession to heal by itself. In general, Hayek does not support the temporal fiscal stimulus package advocated by various governments. However, Hynes is of the opinion that governments should do intervene and do something during recession. As opposed to Hayek, Hynes supports the temporal fiscal stimulus initiated by government to heal the ailing economy. Policy Tools Recession is part of normal economic cycles, which is characterized by decrease in gross domestic product of an economy for two or more consecutive years. This means that the economy does not operate at its full employment of its gross domestic product .It is usually followed by increase in unemployment and poor performance of the stock market The government may employ various measures to counter the recession times; these policies include fiscal, monetary and supply side policies. 1. Fiscal policies These are the measures taken by a government to influence an economy, through the use of taxation and spending .The government does this with the aim of stabilizing the prices, employment level, and the growth of the economy. They include consumption, investment, government spending and net exports Aggregate Demand=Consumption + Investments + Government Spending + Net exports For the government to be able to fully affect the components of aggregate Demand it may either use expansionary or contractionary fiscal policies. An expansionary fiscal policy refers to measures which increase the government spending and or lower the taxes. During recession the GDP of an economy operates at a level lower than its full employment. Therefore his gap needs s to be closed through increasing government spending and raising taxes. Increased government expenditure increases the demand for goods. Contractionary policies are characterized by reduction of government spending and increase in taxes. The decrease in government spending leads to decrease in demand for aggregate goods while the increase in taxes results to less income to spend thus less demand for goods by the citizen’s .Adverse shift in aggregate supply both in the long and short run graph. The above graph shows an economy at equilibrium however, an adverse shift in aggregate would move the economy from C to in the short run and A in the long run. 2. Monetary Policies These are the measures a government may employ to control the supply of money into the economy with the aim of stabilizing the economic growth, inflation rate and the interest rate. The monetary policy may either be expansionary or contractionary.Expansionary increases the supply of money while the contractionary decreases the supply. Expansionary monetary policy is usually used during a recession period with the aim of expanding the businesses to curb the recessionary period. Contractionary policy on the other hand is used to control inflation this restoring the purchasing power of the people. Monetary policy uses various tools to correct the economic cycles such as recession which include; money demand, money supply and reserve requirements. Money Demand During a recession period the government aims at increasing the demand for money. The demand for every product is directly influenced by price; the price for money is interest. Therefore for demand of money to increase the government is required to lower the interest rates which may either be borrowing or lending interest rates. However the lending system needs to be checked carefully such that it does not create liquidity traps situations. Money Supply Another tool that the government may employ is the use of money supply .This involves the government controlling the amount held by its citizens .it can accomplish this through selling the government securities such as bond where it requires to reduce the supply. This will increase the aggregate demand thus shifting the aggregate demand curve to the right to correct the recessionary gap. Reserve requirements The monetary authorities’ controls the banks in any economy, through these mandates the authorities may increase or decrease the reserves held by the banks thus altering the amounts available for lending. During a recession period the government may instruct the reserves to be reduced so as to increase the amount for loaning by the banks. This will thus help in correcting the recessionary gap through increasing the aggregate demand. The above graph portrays an economy at equilibrium, however any adverse shift in the aggregate supply would shift the equilibrium from point C in the short run to D and point A in the long run. 3. Supply side policies These are government direct intervention measures of correcting the recession effects. They aim at shifting the aggregate supply curve to the right. This may be achieved through the employment of such measures as controlling unemployment through, increasing training of workers, reducing social security payments, lessening the disincentives presented by taxation and enhancing the easier flow of finance to firms, removing restrictive practices and so forth. Expanding the supply of money and lowering the rate of interest should have the effect of stimulating the economy. The above graph shows un balanced economy however an adverse change of the aggregate supply would result to the shift of equilibrium point from point C in the short run to Point A and point D in the Long run. References Afonso,A, & Sousa,RM2009, The Macro economic Effects of fiscal Policy, Viewed 30th June 2015, . Beaudry, P, Galizia, D & Portier, F2014, Reconciling Hayek’s and Keynes’ view of recessions, viewed 30th June 2015 < http://www.bis.org/events/conf150310/beaudry_galizia_portier.pdf> Brewer, M, Browne, J, Hood, A, Joyce, R & Sibieta, L2013, ‘The short-and medium-term Impacts of the recession on the UK income distribution,’ Fiscal Studies, vol. 34, no. 2, pp. 0143-5671. Claessens, S & Kose, MA 2009, What is a recession? viewed 30th June 2015 Carling, R 2012, Keynes, Hayek and the Great Recession, Viewed 30th June 2015, Dorman, P2014, Macroeconomics: A fresh start, Springer, New York, NY. Devereux, M & Fuest, C2008, A fiscal stimulus package for the UK, Hills, S, Thomas, R, & Dimsdale, N 2010, The UK Recession In Context - What Do Three Centuries Of Data Tell Us?’ Bank of England Quarterly Bulletin, 50, 4, pp. 277-291. Khan, J & Calver, J2014, Measuring National Well-being: Economic well-being, viewed 30th June 2015 Miller,R.(2013). What Hayek Would Do How Austrian Economists Would Fix The Crisis And Stop It Happening Again? Viewed 30th June 2015, Roberts, R2010, ‘Keynes, Hayek and the Great Stimulus Debate,’ Economic Data and Commentary, vol. 7, no. 8, pp. 1-10. Roberts, K 2015, Social Class and Leisure during Recent Recessions in Britain, Leisure Studies, 34, 2, pp. 131-149. Simpson, D 2009, The Recession Causes and Cures, Viewed 30th June 2015, Simpson, D2009, Recession: causes and cures, viewed 30th June 2015 Vaitilingam, R n.d, Forty Findings from Economic and Social Findings, Viewed 30th June 2015, Read More