A recession is a period in which an economy experiences a decline in national output. It is usually associated with high unemployment level, a decline in the stock market and in other sectors that drive the economy. Economists consider recession as a less severe form of depression though it eventually culminates in depression. In an attempt to remove the economy from the recession, the federal government would engage expansionary economic policies. However, these policies are only applicable to a controlled economy where the government directly intervenes to return the economy to equilibrium (Mertens & Ravn, 2011). The Keynesian economists are great advocates of government interventionists’ measures. They argue that the economy self-adjustment proposed by the classical economists take too long to return the economy to the equilibrium level. The paper will categorically analyze the expansionary fiscal and monetary measures that the government should employ to return the economy to full employment level.
Expansionary Fiscal Policies
Economists define fiscal policies as a set of interventionist measures used by the government to influence the economic growth through taxation and federal spending. Expansionary fiscal policies are applied when the economy is in recession. Usually, this involves tax cuts and an increase in government spending. The objective is to spur the growth of the economy and lower the unemployment level (McKibbin & Sachs, 2011). This is achieved by raising the aggregate expenditure and aggregate demand through tax cuts and increase government spending on capital expenditure. The expansionary fiscal policies usually result in budget deficit due to the decreased tax revenue to sustain the increasing federal spending.
Tax is a key component of government revenue that is administered by the Internal Revenue Service (IRS). During the recession, the federal government instructs the IRS to introduce tax cut and thus increasing the household’s disposable income. A high disposable income means that households have more income to spend. As a result, this leads to an increase in the level of consumption in the economy that in turn increases the national output. Further tax cuts signal businesses that the government is willing to revive the economy from recession (Hebous, 2011). The measure would lead to increase the confidence of business owners and other investors and in turn increases the level of private investment. Aggregate investment is a major component of the national output; thus a high level of aggregate investment translates to an increase in the Gross Domestic Product (GDP).
Government spending is one of the major fiscal tools available to the federal government. Increasing the level of government spending on capital expenditure and recurrent expenditure would help stimulate the economy. Examples of capital expenditure include construction of roads and other infrastructure. On the other hand, an example of recurrent expenditure includes increasing salaries of civil servants and other state employees. Increased government spending often results in budget deficits. In such cases, the government may opt to borrow either from local banks or foreign entities such as the IMF. Increased allocation for government expenditure boosts the household income, decrease the level of unemployment and increase aggregate demand. Government spending as a fiscal policy tool has for long been used as an expansionary fiscal policy tool though it is more involving. For this reason, the most government usually opts for tax cuts that have proved to be a more effective fiscal policy tool.
Effects on aggregate demand
During a recession, there is a low aggregate demand thus leading to lower national output, high unemployment lever, and low price level. The expansionary fiscal policies discussed above help stimulate the aggregate demand in the economy. A fiscal policy such as tax cuts increases the disposable income of households. A high income means that the households have a higher purchasing power. As a result, this leads to an increased spending on consumer goods. As aggregate spending increases the aggregate demand also increases. On the other hand, an increase in government spending raises the level of income in the economy (Catte, Cova, Pagano, & Visco, 2011). This is because it lowers the level of unemployment as more people secure job in the projects initiated by the government. Moreover, increased government spending on recurrent expenditure such as salaries increases the income level of civil servants. A higher level of income in the economy results in the increase in private investment and aggregate spending. The increases in spending and investment level stimulate aggregate demand and thus returning the economy to full employment.
Effects on the GDP
The effect of expansionary fiscal policies on Gross Domestic Product can be best explained using the fiscal multiplier concept. The fiscal multiplier can be described as the ratio of the change of income level in the economy to the change in government expenditure that caused the change. When the fiscal multiplier is greater than one, the change in national income is referred to as the multiplier effect. The multiplier effect occurs when an increase in the government spending leads to a greater increase in the national income. Economist uses the multiplier effect to assess the effectiveness of increasing government spending or tax cut to stimulate the growth of national output. A federal government spends $2 million on a construction project (Hebous, 2011). Most of the funds will be used to pay the workers and provide revenue to suppliers of construction material. This means that the workers, as well as the suppliers, will have a higher disposable income, and in turn their consumption level may rise. An increase in consumption translates to increased level of aggregate demand and thus increasing the national GDP.
Effects on the Employment Level
According to Keynesian economists, expansionary fiscal policies can effectively reduce the level of unemployment in the economy. During the recession, tax cuts or increased spending stimulates aggregate demand that in turn results in increased level of output. A higher national output results in job creation. On the other hand, classical economists refute this line of thinking arguing that expansionary fiscal policies cause a temporary increase in national output. According to classical economists, the fiscal policy tools cause inflation and not an increase in GDP. They also suppose that reduction in unemployment rate requires not only fiscal policies but also supply side policies (Catte, Cova, Pagano, & Visco, 2011). An example of supply side policy includes the cutting down powers of labor unions.
Both the Keynesian and classical arguments are valid and factual. Despite the limitation of expansionary fiscal policies, they can reduce cyclical unemployment. However, the policies cannot reduce frictional and structural unemployment. For instance, a former manual laborer in a mine field who fail to get a job due to lack of skills (Mertens & Ravn, 2011). In such a situation, supply side policies are needed. Increasing the government spending or introducing tax cut cannot solve cannot employment for the laborer.
Expansionary Monetary Policies
The main objective of expansionary monetary policies is to stimulate economic growth and reduce the level of the unemployment in the country. The expansionary policies are applied during the recession by lowering the level of interest in an attempt of increasing the money supply. The government through the Federal Reserve Bank employs a variety of monetary policies tools to encourage private consumption. Some of these tools include the required reserve ratio, discount rate, and open market operation.
The Required Reserve Ratio
The required reserve ratio is the amount of depository that commercial bank must hold. The Federal Reserve Bank determines the ratio. For instance if the US federal reserve bank sets the reserve ratio at 10%, this means that banks must hold 10% of their depositors money as a reserve. If a particular has a deposit of $100 million, it is required to hold $10 million in its reserves. During the recession, the US Federal Reserve will lower the cash reserve ratio. This ensures that commercial banks have an extra amount of money to lend to the public. An increase in credits increases the level of spending and private investment. Moreover, increased level of credits will entice business owners to expand their operation and thus reducing the level of unemployment. The situation in turn stimulates the aggregate demand and increase the level of national output.
The discount rate is the interest rate at which the Federal Reserve Bank lends credit to commercial banks. The discount rate is an important monetary policy used by the government to influence the economy. The recession is usually characterized by a diminished aggregate demand and output, and high unemployment level. The government always lowers the discount rate to remove the economy from recession. Therefore, this in turn results in reduced cost of credit in the economy. The reduction in discount rate encourages private investment and consumption due to the available cheap credit. According to economists, aggregate demand is the summation of investment and consumption. The increase in aggregate demand results in the increase in national output and reduction in the unemployment level in the economy.
Open Market Operation
Open market operation (OMO) involves the buying and selling of government securities in the open market. The open market operation is a major monetary policy tool used by the government to influence the supply money in the economy. The recession is usually characterized by a low supply of money and a diminished aggregate demand. The government through the Federal Reserve Bank will buy government securities from the public, and this will result in the economy moving back to full employment. The action leads to increase in the supply of money in the economy. The increase in money supply in turn results in an increase in the income level. As a result, this leads to increased level of spending and thus stimulates aggregate demand.
Effects on money supply
Expansionary monetary policies result in an increase in the supply of money in the economy. Decreasing the required reserve ratio automatically results in increased the level of credit available to the public. The reason is that a lower reserve ratio means that more funds will be available to commercial banks for credit creation. Households and business owners will be in a position to easily acquire credit from the banks. The Federal Reserve Banks can also decide to increase the amount of money in the economy by lowering the discount rate. Decreased discount rate will increase excess reserves in the commercial banks. Therefore, the commercial banks will have enough money to lend to individuals and business operators. The buying of government securities held by the public by the federal government directly influences the supply of money. The Federal Reserve Bank will increase the money supply by purchasing government securities from the banks and also the public. Besides, the banks will use the funds generated from selling securities and loan to businesses and individuals. The result of accessibility to loans by individuals and business is an increase in money circulation.
Effects on interest rate
Expansionary monetary policies have a negative effect on interest rate in the economy. The government action of decreasing the discount rate results in a decrease in interest rate in the economy. The decrease in the rates of interest causes more borrowers to access capital for investment. Precisely, the action taken by the government will lead to increase in private investment. Moreover, easier access to capital will stimulate the overall economy of the country. Additionally, the buying of government bonds from the public puts a downward pressure on interest rate and thus increases the level of investment. The action by the Federal Reserve Bank will allow the financial institutions to increase lending. It is because of the lower interest rates are lower and also, consumers are willing to take credit.
Effects on spending
A lower cash reserve ratio results in an increase in the credit available to the public, and this will result in an increase in household spending on investment goods. Additionally, a low discount rate lowers the cost of borrowing (McKibbin & Sachs, 2011). Therefore, this means more people can easily access credit from commercial banks. Increased credit level translates to increase in household spending on consumer and investment goods. Similarly, when the Federal Reserve Bank purchases government security from the financial institutions, it increases the amount of money available for the banks to give as credit. Therefore, when people access credit, their spending power will increase. Moreover, people can also get funds by selling government securities.
Effects on aggregate demand, GDP and employment
Expansionary monetary policies result in the increase in aggregate demand, GDP, and offset unemployment level. The monetary policy tools objective is to increase the supply of money and to reduce the interest rate. The increase in money supply will increase the consumer spending power. Therefore, this will also increase the level of aggregate demand. Similarly, a low-interest rate leads to an increase the level of investment that in turn increases aggregate spending (Mertens & Ravn, 2011). As a result, this stimulates the aggregate demand and increases the GDP. The expansionary monetary policies also address the issues of unemployment. The reduction in interest rate lowers the cost of obtaining bank credits thus this entice business to expand. Through this more jobs are created in the private sector.
The government and Federal Reserve steer our economy by using two powerful tools. The tools have guided our economy in the right direction and they include fiscal and monetary policy. However, Keynesian economists advocated expansionary economic policies as measures to revive the economy. Keynes argued that allowing the economy to self-adjust takes long to return the economy to full employment level. Additionally, prolonged recession culminates to a depreciation that is more severe. Therefore, government interventionist measures such as expansionary monetary and fiscal policies are more effective and recommended by modern economists.
Mertens, K., & Ravn, M. O. (2011). Understanding the aggregate effects of anticipated and unanticipated tax policy shocks. Review of Economic Dynamics, 14(1), 27-54.
McKibbin, W. J., & Sachs, J. (2011). Global linkages: macroeconomic interdependence and cooperation in the world economy. Brookings Institution Press.
Hebous, S. (2011). The effects of discretionary fiscal policy on macroeconomic aggregates: a reappraisal. Journal of Economic Surveys, 25(4), 674-707.
Catte, P., Cova, P., Pagano, P., & Visco, I. (2011). The role of macroeconomic policies in the global crisis. Journal of Policy Modeling, 33(6), 787-803.
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