Implications for Macroeconomic Policy - Essay Example

Explain and discuss the golden rule of accumulation and assess the implications for macroeconomic policy For overall development and wellbeing of thenation it is very important that its economy grows. If the population of the country is experiencing a hike there is also a possibility that more output is being produced and this will contribute towards the nation’s economic growth (Burda and Wyplosz, 2009, p.4). Growth is dependent on the savings income ratio and net savings and investment are found to be proportional to income and the produced output of the nation. The ongoing technological progress also has a positive impact on the growth of the economy (Solow, 1994). All such factors are considering by policy makers while implementing macroeconomic policies for the country. The savings investment behavior of the economy can be captured through neoclassical economics including the golden rule of accumulation. The golden rule is adopted to move towards optimum consumption. The golden rule determines the desired level of savings since under this level all profits are saved and then reinvested (Baumgartner and Meredith, 1995, p.6). Thus the current paper tends to discuss the golden rule of accumulation and its implications for macroeconomic policies. The production function of a country depicts how the country utilizes the available resources and inputs for producing output. Land, labor, capital and organization are termed as factors of production. We mainly use capital (K) and labor (L) as the two factors. It is given as, Y=f (a1, a2,……, an) , where Y= the output; a1, a2,……,an = the inputs Production function differs in short run and long run when all inputs vary (What is Production Function) Equally important as production is the concept of consumption which is the difference between income and savings. The consumption function depicts the relation between consumption and disposable income (Consumption Function). It is given as, C= C0 + c(Y-T) Where, C0 = autonomous consumption (Y-T) =disposable income c= marginal propensity to consume Graphically consumption function may be presented as follows: Attainment of steady state means that an economy has gained stability. A country has attained steady state either due to increase or decrease in growth. It occurs when production rates or the country’s investment equals depreciation. Such a phenomenon is shown in the diagram below: B B depreciation (δk) o/p labor ratio A savings sf(k) K/L ratio k1 k2 k3 Here it is seen that under the steady state output labor ratio becomes stagnant as investment becomes equal to depreciation at point A. production function determines the output- labor ratio at point B. Away from A the economy is converging towards steady state. Golden Rule of accumulation and savings Under the steady state the government requires to choose that level of savings which maxims consumption per worker. The steady state containing highest amount of possible consumption is given by golden rule level of capital accumulation. This may be determined through knowledge of consumption of each laborer (“The Golden Rule”, n.d) assumed to be k. When the economy has attained the steady state the growth becomes dependent positively upon the savings-investment ratio and decreases with further increase in population (Thirlwall, 2002, p.22). If capital increases under steady state it will also increase output. The steady state consumption per worker is, c=f (k)- δk Such a golden when viewed from marginal product of capital where an additional unit of capital leads to an increase in output. At steady state marginal product equals sum of population growth, labor growth and depreciation rate. This is shown in the diagram below: Output-labour ratio (δ+n+g)k y = f (k) sf(k) Capital-labour ratio An economy mainly deviates from steady state in order to maximize its consumption. According to the golden rule consumption reaches optimum level when marginal gains accrued from an extra unit of investment in capital equals the rate of depreciation. However for efficient economy maximization of consumption is achieved only if sufficient sacrifices are made previously. For an inefficient economy consumption can be increased through reduction in savings. Both the cases are highlighted in the figure below: Consumption Consumption 1. Dynamically efficient case 2. Dynamically inefficient case The golden rule level is encountered when the economy is deviating from steady state in order to increase welfare. The savings rate that is found on another level is regarded as suboptimal. It determines the savings rate and capital that the economy is expected to obtain in the long run (Baumgartner and Meredith, 1995, p.6). The golden is illustrated below diagrammatically: A Y=f(k) Depreciation consumption Investment In the diagram above the steady is the vertical distance between the production and depreciation. Consumption is maximized at A where depreciation equals marginal productivity of capital. Golden rule allows the economy to choose the desired level of savings that maximizes consumption. However total savings of the economy is related to the workers’ propensity to save. This again depends on the level of output created. Such a phenomenon is shown in the figure below: F(k1) Y=f(k) F(k2) F(k3) Savings=s. f(k) K1 K2 K3 From the above figure it is seen that different level of output contributes towards different levels saved by each worker and is related to capital per worker. Hence the macroeconomic policies of the country should be directed towards accumulating more capital for the country generating desirable savings for overall growth of the economy (The steady state, n.d). It is important for the economy that level of savings (s.f(k)) equal the amount invested(δk). If investment is greater than level of savings, capital stock of the economy will fall. This is shown in the figure below: δk Y/L y=f(k) s.f(k) K/L k* k Similarly if individuals in an economy tend to save more than invest, the amount of capital in the economy will rise but that will not generate maximum amount of profits (The steady state, n.d). Hence the desired level of savings is considered as the one at steady state recommended by the golden rule of accumulation that leads towards golden growth (Phelps,1961). Implications for macroeconomic policies Clearly the government has to adopt macroeconomic policies keeping in mind the savings rate (Carlin and Soskice, 2006, p.507). Golden rule of accumulation has been termed important for framing governmental policies through planning of governmental spending in accordance with the tax revenue (Riley, 2006). The golden rule has always recommended the economy to save and at the same time maximize consumption. The golden rule helps to determine that propensity of savings that is directed towards optimal consumption. However savings totally depends upon the earning of individuals. Positive net savings can contribute to the economy for fulfilling the objective of desired investment for economic growth. (Levacic and Rebbman, 1982, p.81). Golden rule is thought of as essential for achieving balanced growth. The life cycle growth models in economics cannot get the economy to optimal levels. Intergenerational transfers come in between their maximization policies. But under golden rules optimal levels can be achieved (Chamberlin and Yueh, 2006, p.6). When the economy is at golden rule level it maximizes consumption and thus leads to improving welfare of current generation. Being below the golden rule level the economy needs to invest more to reach to that level. This may lower consumption for the current generation but such investment will increase consumption for the future generation. Hence policy makers consider the golden rule level for welfare maximization (“The Golden Rule”, n.d). For intergenerational distribution uncompensated interest elasticity of savings governs the impact of tax policy. Steady state generations benefit from golden rule growth at the cost of transitional generation. Such benefits are obtained by eliminating capital income taxation (Aeurbach and Feldstein, 2002, pp.1191-1192). The Golden rule is beneficial for increasing the standard of living in an economy. Transferring resources from investment to consumption, the policy makers encounter a trade-off between current and future generations. The Swedish economy can be sited as an example which by adopting the Golden Rule has managed to obtain the highest living standards. Maintenance of golden rule standard for a long time helps the country achieve higher standards of living. But at the same time the country needs to concentrate on capital formation. However under international trade the country also needs to make significant investment in technology (Bosworth and Rivlin, 1987, p.262). Without the economy getting into the golden rule standards the country can have more or less savings. More savings can be considered detrimental to the country’s wealth. If the individuals are saving more it may be investing less which is not desirable for the economy. Golden rule is also determined by policy makers for poverty reduction. As golden rule specifies the level for consumption maximization policy makers make alterations accordingly in the system, e.g. in the tax system so that people can have more wealth for themselves and increase consumption. Such a trend is found in income tax system where people pay taxes according to their income. Government has also lowered the starting rates of income taxes so that people can have more of their income for their own consumption (Riley, 2006). Overall this beneficial tax system can help to reduce poverty by increasing individual consumption. Conclusion The golden rule of accumulation is concerned with determining the level of savings that will optimize consumption and is also consistent with savings rate. The rule has far reaching implications for macroeconomic policy framing and thus helps the policy makers to undertake policies focusing on savings or dis-savings. It brings out the importance of savings and investment in terms of injections and leakages. Defining credit market and availability of loans the golden rule of accumulation is claimed to be far more than the life cycle growth models. Such a rule is also favorable for achieving balanced growth. References: 1. Aeurbach, AJ and Feldstein, MS. (2002). Handbook of Public Economics Volume 3, Amsterdam: Elsevier Science 2. 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