The Macroeconomic Environment: Expansionary Fiscal Policy - Essay Example

Question What is fiscal policy? What factors or possible problems should a government consider when devising an expansionary fiscal policy? FISCAL POLICY David Weil (2002) defines fiscal policy as the usage of the budget of government for influencing the economy. He identifies three (3) ways to which the government does fiscal policy: (1) deciding on the taxes it collects, (2) deciding on the transfer of payments it gives out, and (3) deciding on the goods and services it purchases. With regard to the effect of fiscal policy on the economy, it targets the macroeconomic sector in which the macroeconomic variables like GNP, unemployment, and inflation are affected. (Weil 2002) STATES OF FISCAL POLICY Fiscal policy has two situations which are differentiated by government deficit or the “difference between what the government pays out (government expenditure) and what it takes in (tax revenues).” (Weil 2002) The first state is the contractionary or tight fiscal policy wherein the government expenditure is lesser than its revenues or budget surplus. On the other hand, it is called expansionary or loose fiscal policy when government spending is larger than its revenues resulting to budget deficit. (Weil 2002) FISCAL EXPANSION In devising a fiscal expansion policy, the government should consider certain economic indicators and factors that are affected. These are interest rate, exchange rate, trade balance, Gross Domestic Product (GDP), and aggregate demand. Weil (2002) and Hemming et al. (2002) observe the possible effects of fiscal expansion on these factors which contribute for economic stability. Richard Hemming et al. (2002) see expansionary fiscal policy as beneficial in stimulating economic activity. They use the events like Asian Financial Crisis of 1997 and recessions in Europe and the United States as empirical evidences of the negative effects of contractionary fiscal policy through strong tax systems. Weil (2002) sees beneficial effect of fiscal expansion on managing the economy through the gross domestic product (GDP) or the total amount produced. Fiscal expansion results to increase in demand for goods and services which in effect raises both the output and price. However, the degree of increase on these two factors depends on the state of the economy according to Weil (2002). “If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.” (Weil 2002) Weil (2002) states fiscal expansion raises the aggregate demand or the total demand for final goods and services available in the economy at a given price and time. The increase in aggregate demand due to fiscal policy happens in two ways. First is when the government increases spending while maintaining taxes, it will result to a direct increase in the aggregate demand. The second way is when the government initiates tax cuts or transfer payments increase, the disposable income rises leading to an increase in consumption. Fiscal expansion also changes the “composition of aggregate demand” through crowding out of private investment due to rising interest rates accompanied by competition between the government and private borrowers. (Weil 2002) Hemming et al. (2002) mention that crowding out through interest rates as well as exchange rate is influenced by “features IS-LM (Mundell-Fleming) framework” like: (1) “determinants of private investments, (2) money demand and monetary policy, and (3) openness and the exchange rate regime.” (Hemming et al. 2002) Another effect of fiscal expansion is on the exchange rate and trade balance. The government borrows through the issuance of bonds which raises the interest rate. The rise in interest rate would attract foreign capital and investment. This results to appreciation of the currency which makes foreign goods cheaper and exports more expensive. The change in trade balance is negative because imports outweigh the exports. (Weil 2002) Hemming et al. (2002) add that fiscal expansion in a fixed exchange rate regime will produce lesser increase to interest rates for open economies than for closed economies. With regard to rising interest rates following an increase in government borrowing, monetary policy can bring back the interest rate to normal through increasing money supply. (Hemming et al. 2002) List of References Hemming, Richard, Michael Kell, and Selma Mafhouz. 2002. ‘The Effectiveness of Fiscal Policy in Stimulating Economic Activity – A Review of the Literature. International Monetary Fund. Pp. 1-52. Weil, David N. 2002. ‘Fiscal Policy’. The Concise Encyclopedia of Economics. Indianapolis: Liberty Fund, Inc., ed. David R. Henderson. [Online]. Available at: http://www.econlib.org/library/Enc/FiscalPolicy.html [accessed 11 August 2008]. Question #3: Distinguish between different kinds of unemployment. What kind of unemployment can be reduced by supply side policies and what specifically could those policies be? UNEMPLOYMENT The International Labour Organization (1982) describes the unemployed as “all persons above the specified age who during the reference period were: (1) without work, (2) currently available for work, (3) seeking work.” (International Labour Organization 2002, par. 10, no. 1) The first condition defines persons who are not in self-employment or paid employment. The second condition describes persons who are available for self-employment or paid employment during the reference period. The third condition describes persons who had taken specific steps in a certain period to seek for self-employment or paid employment.(International Labour Organization 1982) TYPES OF UNEMPLOYMENT Goodwin et al. indentify three (3) types of unemployment namely: (1) frictional unemployment, (2) structural unemployment, and (3) cyclical unemployment. These categories assist the economists in finding the major causes of unemployment A. Frictional Unemployment Frictional unemployment highlights the transitions of people between jobs. Goodwin et al. emphasize that unemployment does not mean that no job is available. The data they gathered in April 2006 – showed 7 million people who are unemployed and 4.1 million job vacancies – reflect their argument. The authors also take into consideration the importance of finding the right job instead of taking the first job offered. Currently, frictional unemployment rate is 2-3% and economists suggest that web technologies may enhance job matching which will shorten the time duration for job searching. (Goodwin et al.) B. Structural Unemployment Goodwin et al. identifies structural unemployment as a condition that occurs in the presence of job mismatching between employers and the “skills, experience, education, and geographical location” of candidates for a certain position. One major cause of this type of unemployment is sectoral shifts or the rise and fall of employment in different sectors. Structural unemployment brings both positive and negative impact according to Goodwin et al. For the positive side, structural unemployment brings “technological and entrepreneurial innovations” which contribute to economic growth as well as better job opportunities. However, this also hits the people who are working in the falling sectors. Because of new technology, their specialities will be outdated which will result to lesser job opportunities and depreciation of their human capitals. (Goodwin et al.) C. Cyclical Unemployment Cyclical unemployment happens during macroeconomic fluctuations which changes the aggregate demand. When the business cycle worsens, – leading to a recession – the demand for products of businesses falls and increases unemployment. On the other hand when recovery occurs, cyclical unemployment is expected to decline. This kind of unemployment is regarded by the economists as their major concern compared to frictional and structural employment. It is because cyclical unemployment affects the economy on a wide range which causes economic problems. (Goodwin et al.) SUPPLY-SIDE POLICIES Gary Burtless (2001) focuses on reducing the structural unemployment by introducing supply-side policies that were implemented in North America and the Organisation for Economic Co-operation and Development (OECD) Region. The United States implemented two “micro-economic supply-side policies in the 1980’s. The first one is the establishment of earning supplements that are payable to low income workers and encourage them to find and keep their jobs. The second policy is reforming “American social assistance programs” to limit income support payments duration and to “link support benefits to worker’s active participation in job search.” (Burtless 2001, p. iii) The policies were categorized in two approaches. The first approach is on policies that were designed to “encourage work among the unemployed by improving: (1) incomes of jobless adults who accept jobs, or (2) incentives for employment creation”. (Burtless 2001, p. 1) The second approach is on policies that try to “discourage long-term unemployment by reducing the attractiveness of public transfers” by: (1) decreasing transfer benefits, or (2) charging burdensome requirements to adults who continue to get government transfers. (Burtless 2001, p. 2) These policies target to reduce unemployment by: “(1) curbing workers’ incentive to remain unemployed by altering public transfer programs that supports jobless workers, (2) increasing the attractiveness to work by boosting the net income available to unemployed workers who accept jobs, (3) improving the human capital of jobless workers to make them more employable, and (4) increasing the attractiveness to employers of hiring and training the unemployed ...” (Burtless 2001, p. 2) List of References Burtless, Gary. November 2001. ‘Can Supply-Side Policies Reduce Unemployment? Lessons from North America’. Center for Economic Policy Research. Australian National University. Pp. 1-39. Goodwin, Neva, Julie A. Nelson, Frank Ackerman and Thomas Weisskopf (Contributing Authors); Global Development and Environment Institute (Content Partner); Cutler J. Cleveland (Topic Editor). 2008. ‘Types of unemployment.’ Encyclopedia of Earth. Eds. Cutler J. Cleveland (Washington, D.C.: Environmental Information Coalition, National Council for Science and the Environment). [Online]. Available at: http://www.eoearth.org/article/Types_of_unemployment [accessed 11 August 2008] International Labour Organization. 1982. Resolution concerning statistics of the economically active population, employment, unemployment and underemployment. Thirteenth International Conference of Labour Statisticians. [Online]. Available at: http://www.ilo.org/public/english/bureau/stat/download/res/ecacpop.pdf [accessed 11 August 2008] Read More