Monetary and Fiscal Policy Implemented in the US during Great Recession - Essay Example

?The Monetary and Fiscal Policy Implemented in the United s During the Great Recession I. Introduction The Great Depression in the United shas become a central point of discussion for fiscal policy makers. Every fiscal decision appears to be referenced to the depression that has ravaged the U.S. economy. There were several strategies introduced by policy makers to combat such occurrences. After all, no economy is safe from depression and market forces continue to follow cyclical trends. The discussion below will tackle some of the important aspects related to depression. These subjects affect all players in the economy. In addition, some concepts will be explored and discussed in relation with the depression. II. Crowding Out The concept of crowding out pertains to the increase in government borrowing leading to reduction in consumption and investments (Blanchard, 2008). When the government decides to bolster spending, the best ways to raise funds are increased taxes and borrowing. In periods when depression is imminent, raising taxes is not a practical strategy. Government will have a hard time convincing the labour force to pay more taxes when community prices continue to rise and jobs become hard to maintain. The logical approach for the government to raise funds is to borrow through treasury bills, sovereign bonds and loans. The proceeds from these activities can used to pump the economy and stabilise spending among all entities. The immediate impact of crowding out can be observed in the investments. When the government borrows, there is a possibility that the interest rates will increase. As interest rates go up, the capacity of private investors to borrow decreases. High interest rates discourage investors to venture in activities that require massive funding. Aside from increasing the interest rate, government borrowing also create problems for companies to borrow from other channels. For instance, when a sovereign bond and a corporate bond are floated debt investors will have to decide which investment would sense (Blanchard, 2008). Governments compete with companies for funds and such hampers any expansion firms have in their pipeline. Some economists would argue that government borrowing is critical during times of depression. The inability of the private sector to sustain growth creates problems for the government (Spencer and Yohe, 1970). Long-term effects of crowding out appear to be beneficial in many ways. More funds in the public sector means spending for infrastructure and other aspects that could aid businesses. Also, the government could start handing out jobs to individuals affected by companies filing for bankruptcy and downsizing firms. When used the right way, government borrowing can fuel lagging economies and facilitate the revival of private investments and consumption. III. Ricardian Equivalence Theory The main proponents of the Ricardian Equivalence theory suggest that consumer will not change even if the government decides to increase taxes. The theory also states that the method in which governments finance their spending has to impact on the overall demand in the market (Barro, 1979). In times of recession and even especially during depression, governments are pressured to spend more. Since businesses start to slow down and consumer spending could also lag, revenue from taxes is expected to be reduced. To cover for the possible budget deficit governments could resort to borrow from available channels. Even if the borrowings will continue to rise, the level of consumption and overall demand will remain the same. According to Buchanan (1976), however, there are several aspects that were not considered when the theory was formulated. There is a difference in perspectives when dealing with borrowing and raising taxes. In addition, the promoters of the theory failed to recognise the varying opinion of the consumers when taxes are increased. Some households value their savings and considered their extra assets as insurance for their families’ future. When taxes are increased, taxpayers would normally tap their savings since their income has not gone up. Moreover, the Ricardian equivalence theory does not cover population growth which affects demand. IV. Rising Interest Rates High interest rates have varying effects to individuals. Some consumers could even withstand such occurrences given their income and spending capacity. The most fundamental reason why interest goes up is to control the supply of money. Oversupply of money leads to inflation and deteriorates the value of household income. When interest rates go up, individuals who plan to borrow are discouraged. Individuals with existing mortgages are also affected especially those who forged debt agreements with flexible interest rates. For instance an individual who has to pay monthly amortisation for a real estate, increased interest rates will affect the period in which the mortgage is settled. Also, instead of using the extra income to pay for the principal, individual with debts will use their extra cash to pay for the change in interest rates. During a period of depression, one of the indicators of improvement is the increase in consumer spending. But when interest rates are high, there exists an incentive for consumers to save their money in bank accounts. Money in banks will remain frozen because businesses that tap these institutions would balk in resorting to more borrowings. Moreover, individuals who have extra money to invest would be discouraged from fuelling the economy. An individual involve in exporting goods and services would be adversely affected by high interest rates. When interest rates are soaring, the value of local currencies appreciates. This leads to lower revenue and could greatly affect the individual’s business in the long run. Consumers also need to watch out the effect high interest rates to the debt of the government. Since the government needs to pay more for their borrowings, some services rendered to the public are also curtailed. High debt servicing means reduced budget for education, safety and health. Some government would increases taxes to compensate for the rising interest rates. This is compared to a double black-eye as consumers would still worry about their own interest rates and the extra tax the being charged by the government. V. Increasing Taxes Approximately 80% of the government revenues are sourced from taxes. These include property taxes, business taxes, income taxes and other special taxes. For an individual, there are several effects of high or increasing tax rates. When taxes go up the burden is usually placed under the shoulders of employees. Income taxes are deducted even before workers get their salaries. This affects the buying power of individuals and the effect could be greatly exhibited in an economy under depression. When consumer spending is down, businesses will eventually lose revenue inflow In the long run, the government will have to compensate for the stagnation in the private sector. This is a possible no-win situation because companies would start to close down and employees will become unemployed reducing tax collections. Bibliography Barro, R.J. (1979), Journal of Political Economy, "On the Determination of the Public Debt" Pp. 940-971 Blanchard, O.J. (2008), The New Palgrave Dictionary of Economics, “Crowding Out” Buchanan, J.M (1976), Journal of Political Economy, "Perceived Wealth in Bonds and Social Security: A Comment" Pp. 337-342 Spencer, R.W. and Yohe, W.P. (1970), Federal Reserve Bank of St. Louis Review, “The 'Crowding Out' of Private Expenditures by Fiscal Policy Actions” Pp. 12-24 Read More