Discuss monetary policy and fiscal policy’s importance for the USA, in the light of stagflation.

Introduction to Monetary and Fiscal Policy, and Stagflation

Monetary policy means to control the money supply and interest rates to affect aggregate demand (AD) in an economy, according to what is known as demand-management. Fiscal policy is another demand-management policy that deals with manipulating government spending and direct taxes so as to affect AD. Stagflation is defined as a situation of low economic growth with high inflation - both stagnation and inflation. Inflation is defined as a persistent and sustained increase in the general price level (GPL), that poses a problem to society because this increase in GPL is sustained and inordinate. 

This Economics paper discusses the strengths and limitations of monetary and fiscal policy, each in turn, in relation to stagflation in the USA. This paper concludes that both policies are equally important for the US, but they should be used in conjunction with supply side policy. 

Monetary Policy

Monetary policy works, in theory, by two ways. First, according to the classical direct transmissions mechanism, increases in money supply help consumers spend more and firms invest more directly because they have more money and they feel richer. Second, according to the indirect transmissions mechanism, increases in the money supply lower the interest rate, which lowers the cost of borrowing. Since it is cheaper for households to borrow money to consume, and cheaper for firms to borrow money to invest, C and I both increase, and since AD = C + I + G + (X-M), then AD increases, which helps to solve unemployment and which also causes actual economic growth. 

Unemployment is defined simply as the situation where people who are able and willing to work cannot find jobs, or they are unwilling to take up the jobs at the wage rate given to them. Actual economic growth merely refers to increases in real output at the macroeconomic level caused by increases in AD. Hence, it would seem that prima facie, monetary policy can help solve unemployment and lack of growth in the USA, and hence fight stagflation by countering the “stagnation” part.  

Limitations of Monetary Policy

However, monetary policy might suffer from the liquidity trap, which means that beyond a certain point interest rates cannot be lowered further, thus hampering the workings of monetary policy. If interest rates cannot be lowered, the costs of borrowing cannot be reduced. This can be seen in an analysis of the liquidity preference theory put forth by Keynes. 

Fiscal Policy

On the other hand, Keynesian fiscal policy works when governments spend more, for instance on national defence and education, or when they tax less, through lowering income and corporate taxes. Increasing G raises AD directly given that G is one of the components of AD. Lowering direct taxes cause C and I both to increase, and since AD = C + I + G + (X-M), then AD also increases, which helps to solve unemployment and which also causes actual economic growth. Because of the multiplier effect, where the multiplier means that national income increases by a factor more than the initial increase in the injections into the economy, the USA’s AD will increase, promoting and boosting growth. 

In the USA, both C and I are large components of the AD. It can also be argued that G is also a big component given that the USA has a large military. Hence, it would seem that prima facie, fiscal policy can also help solve unemployment and lack of growth in the USA, and thus fight stagflation by countering the “stagnation” part.  

Limitations of Fiscal Policy

However, there are also limitations to fiscal policy, one of which is the famous “crowding out effect”. If governments run a budget deficit, and the USA is arguably famous for running both a budget as well as a trade deficit for many years, then they will have to borrow money. According to the loanable funds theory, this increase in demand for funds by governments will crowd out private consumption and investment, and hence C and I will fall despite G increasing, thus negating the effects of fiscal policy. The US government would be “crowding out” private consumption and investment. 

Supply Side Policies?

Hence, supply side policies that target the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise, could be better for the USA in handling stagflation. Subsidies for energy and other natural resources, increases in the US labour force in both numbers and quality, for instance by increasing American high school education and human capital, and increases in both the quantity and quality of American capital, plus encouraging immigration especially of entrepreneurial foreigners, would help massively. 

These methods and means would shift the AS curve both down and to the right and help solve cost push inflation in the USA. These would be better because they would solve both the “lack of growth” and “high inflation” aspects. 

Conclusion

In conclusion, perhaps both demand side and supply side policies should be used hand in hand, and together they can help solve stagflation because they encourage both potential and actual growth, which is great for the American economy. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay on monetary policy and fiscal policy, set in the context of the USA, is interesting and provides a suitable level of analysis. There are consistent references to the USA as well as relevant macroeconomic policies, and the underlying economic reasoning behind those policies. There are also well-defined terms that are explained clearly. Note: this particular Economics essay on the USA is related to the earlier Economics question on stagflation: Explain possible causes of stagflation in the USA. However, my usual question applies here: if you were the Economics tutor grading this Economics paper, what areas of improvement would you suggest? Let's look, for example, at the conclusion. While this essay's conclusion makes a good argument and tries to justify the argument made, there is a lack of detailed evaluation which could possibly make it an even better essay. What other areas of improvement for this Economics essay do you observe or notice? Thanks for reading and cheers!

Explain possible causes of stagflation in the USA.

Explain possible causes of stagflation in the USA.

Introduction - Possible Causes of Stagflation in the USA

Stagflation, as the name suggests, refers to the macroeconomic situation of low economic growth and high inflation – stagnation and inflation occurring at the same time. The background to this essay is that from 2008-2010 due to the housing bubble crisis in 2007/2008 in the USA, there have been massive rates of unemployment, raising the jobless rate.

This Economics essay argues that the possible causes of stagflation in the USA can be traced to mainly cost-push inflation.

Cost Push Inflation?

First, general cost push inflation could have resulted in stagflation in the United States. Inflation can be defined as a sustained increase in the general price level (GPL), and it could be a problem when the increase in the GPL is sustained, persistent, and inordinate.

Inflation can be both demand pull and cost push, the first affecting the aggregate demand (AD) which equals consumption, investment, government spending, and net exports or C + I + G + (X-M), by shifting it to the right, and the second affecting the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise.

For cost push, increases in unit input costs in the factors of production will lead to the AS shifting upwards, lowering employment, and simultaneously raising the rates of inflation. This can be explained using the AD/AS diagram demonstrating cost push inflation.

For example, first, higher costs of inputs such as oil could have contributed to this situation, because oil is fast running out, and the demand for oil is relatively inelastic, which could lead to high volatility and high prices. Second, wage costs could possibly have spiralled in the USA. Third, capital costs could have increased, but this is highly unlikely given that this is the USA with its technological advantages and its huge supply of capital.

Imported Inflation?

Imported inflation, which generally also leads to cost push inflation, but can also lead to demand pull inflation in some instances, might not have been a major influence of stagflation in the United States. This is because while the USA might accuse China of artificially having low exchange rates, thus increasing their imports of Chinese goods and probably causing some unemployment in sunset industries in the USA, the decreasing AD that results from this situation would actually ease inflation, and not cause stagflation. 

Furthermore, the United States of America is a large country and does not depend on imported inputs that much for the production of her own products or exports. Possibly, the rise in global food and oil prices (commodity prices have been rising internationally) could lead to some imported inflation in the USA, which would have possibly also contributed to shifting the AS curve upwards, increasing GPL.

Quantitative Easing (QE)?

Second, excessive printing of money from the QE exercises (quantitative easing), from around 2008 to 2012, by the USA Federal Reserve (USA’s central bank) could have also led to stagflation in the USA because there could be the case of too much money chasing too few real goods. Also, it can be argued that according to the Fisher Equation, where MV = PT, increases in the money supply cause inflation to occur, corroborating Milton Friedman’s famous statement that “inflation is always and everywhere a monetary phenomenon”.

This might have contributed to the high inflation in the USA because low interest rates encourage borrowing for consumption and investment, which would have caused demand pull inflation to also occur; also, according to the classical direct transmissions mechanism, more money in the hands of consumers and firms would lead to higher C and I, thus boosting AD, which might have contributed to inflation. This could have led to AS shifting upwards due to asset bubbles, which raise the costs of production.

Conclusion

Hence, in conclusion, cost push inflation is likely to be the main cause of stagflation in the USA. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay is about the causes of low economic growth and high unemployment in the USA, and is clearly in reference to recent events, in recent years (around 2007 - 2012). There are many good points about this Economics essay, such as its references to Milton Friedman and the many excellent, relevant, real world examples. However, put yourself into the shoes of an Economics tutor - what would you say were the weaknesses of this Economics paper, and how would you remedy them? Other than the fact that an Economics diagram could have been used (the AD/AS diagram which is already highlighted and put in bold fonts in the essay), what else could have been done better? While this Economics paper is good, how can it be made even better? Thanks for reading and cheers!

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion? [17]

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion?

Inflation brings about some adverse effects to the economy and hence it is important for governments to implement policies to curb inflation. The policies used would differ according to the type of inflation as well as the nature of the economy. This paper discusses if fiscal policy works best to achieve price stability in a small and open economy, and uses Singapore as a case study in particular. First, it should be noted that Singapore is a small and open economy with no natural resources, relying heavily on trade, international capital flows, and foreign direct investments to drive growth. This paper argues that fiscal policy can be used, but its impacts are massively limited given Singapore’s context.

What is fiscal policy?

Fiscal policy refers to the manipulation of government expenditure and taxation to achieve macroeconomic goals. A contractionary fiscal policy could be used to curb inflation. Government expenditure could be reduced or taxation could be increased. With a lower government expenditure, this would translate to a lower aggregate demand (AD) which consists of AD = Consumption + Government expenditure + Investment + Net Exports, or AD = C + I + G + (X-M).

Through the multiplier process, a fall in G would lead to a multiple fall in AD. With a fall in AD, firms would accumulate inventories and this would be a signal to reduce production and output. Firms will reduce their number of workers hence resulting in a fall in output and a rise in unemployment and a fall in national income. With a fall in household incomes, there is a fall in spending and hence through the multiplier process, this would result in a contractionary effect on the economy. Hence, AD would shift to the left as shown, resulting in a fall in the general price level.

With higher taxes such as income taxes, this would reduce the disposable incomes of consumers and hence this would also reduce consumption expenditure, shifting the AD curve to the left, and, hence, also resulting in a fall in the general price level.

Limitations of Fiscal Policy in Singapore’s Context

However, the effectiveness of fiscal policy would depend on the size of the multiplier. In the case of Singapore, the size of the multiplier is small due to the high marginal propensities to save and import. This is firstly due to compulsory savings such as the Central Provident Fund (CPF), and, secondly, a high marginal propensity to import, among other factors. Because Singapore is a small and open economy that relies heavily on foreign trade, there would be high leakages from the economy. Also, it would also be difficult to reduce government expenditure for long-term, major projects. Increasing personal income tax could also result in a disincentive to work and a higher corporate tax could drive businesses away from Singapore.

Other Possible Solutions

On the other hand, the Singapore government can also use contractionary monetary policies (in Singapore’s case, an exchange rate policy), or supply-side policies instead to tackle inflation, rather than just fiscal policy.

Monetary Policy, in Singapore’s Context

Monetary policy refers to the use of interest rates to achieve macroeconomic objectives. In Singapore’s case, her monetary policy is tied to exchange rates, and Singapore uses a form of exchange rate policy because Singapore is dependent on external demand. Therefore, it is more effective to control exports and imports in Singapore’s context. Hence, the exchange rate is used as a tool of monetary policy in Singapore instead.

In Singapore, a managed float system is adopted where the Singapore dollar is allowed to fluctuate within a band against a basket of currencies of her trade partners. The central bank will then intervene in the foreign exchange market to move the exchange rate to a desired level by buying up or selling the Singapore dollar using her foreign reserves, when the currency level approaches the bands. For instance, to curb inflation, the Singapore central bank (the MAS) could buy up the Singapore dollar, resulting in an appreciation of the Singapore dollar. This appreciation of the Singapore dollar would lead to a fall in the price of imports in terms of Singapore dollars. This would lead to a lower cost of living as the price of imported products would be lower. With a lack of natural resources, Singapore depends heavily on imports as inputs to manufacture our exports. Therefore, the fall in the price of imports would lead to a fall in the cost of production.

The lower price of imports would also mean that consumers switch away from local goods and purchase more imports instead, assuming they are substitutes. With an appreciation of the Singapore dollar, this would mean that Singapore’s exports are more expensive in foreign currency terms and hence less price-competitive. Assuming demand for exports to be price-elastic, this would lead to a more than proportionate fall in quantity demanded of exports from Singapore. If the Marshall-Lerner condition holds, this would lead to a fall in net exports and hence a fall in AD. The AD curve would shift to the left, resulting in a fall in the general price level, ceteris paribus.

Limitations of Singapore’s Exchange Rate Policy

However, there are limitations to the effectiveness of Singapore’s exchange rate policy. Intervention in the foreign exchange market to generate an appreciation of the currency would require Singapore to maintain significant reserves. A fall in export earnings through an appreciation of the dollar would also lead to a worsening of the current account.

On the other hand, besides fiscal and monetary policies, the Singapore government could also use supply-side policies to tackle both demand-pull and cost-push inflation. With supply-side policies, the aggregate supply (AS) could be increased through labour retraining and education. By increasing the productivity of workers, in the long run, the cost of production would fall, resulting in a rightward shift of the LRAS curve, leading to a fall in the general price level, ceteris paribus. Cost-push inflation can also be curbed using wage and income policies. For instance, a flexible wage structure would enable wages to be adjusted downwards. In Singapore, the National Wages Council (NWC) recommends the level of wage increases. This could control labour costs and ensure that wage increases do not outstrip productivity increases.

However, supply-side policies would not work effectively if AD continues to increase. Therefore, there is a need to use both contractionary fiscal or monetary policy to reduce AD to reduce the upward pressure on prices. In the long run, supply-side policies are important to curb inflation.

Conclusions

In concluding, it should be mentioned there could also be considerable time lags involved in the implementation of policies. It takes time for policymakers to gather data. There could also be implementation lags due to the time taken to implement suitable policies. Once policies are implemented, there could also be impact lags as it takes time for policies to take effect. Also, due to the characteristics of the Singapore economy, it is arguably better to adopt contractionary monetary policy using exchange rates to curb inflation, as Singapore’s monetary policy is in the form of exchange rate policy. This poses a tricky problem, in that, with a small multiplier in Singapore’s context, the effectiveness of fiscal policy is limited, yet the benefits of supply-side policies might only be reaped in the long run. However, it should also be noted that curbing inflation could lead to a trade-off with another macroeconomic objective of unemployment. By curbing inflation, a fall in national output will occur and that might lead to an increase in unemployment. In the final analysis, fiscal policy is only one of many solutions and its impact is massively limited in Singapore, and as such as plethora of policies should be used instead of one single policy.

JC Economics Essays: Tutor's Comments - This paper was written by an Economics tutor friend of mine, who was my former classmate at the NIE (National Institute of Education), doing PGDE (Postgraduate Diploma in Education, JC, Economics specialisation). For part (a) of this question, see the suggested "model" Economics answer why low inflation is an important macroeconomic aim of the Singapore government.  My usual tutor's comments and questions apply here to this essay: what do you like about this paper, and what have you learnt here? Also, what have you studied that is different or similar to what is written in this Economics paper? Using your knowledge of macroeconomics, what diagram must you use here to explain the words? Remember, although this was written under simulated examination conditions by an Economics tutor, you can always think of other ways to improve it, refine it, and make it better suit the context. Also remember that you should know how and when to apply your Economics concepts and theories, rather than just merely memorising and regurgitating. Be sure to think hard, clearly, and properly when writing your Economics essays, especially during examination conditions. Thanks for reading, and cheers!

(a) Explain why low inflation is an important macroeconomic aim of the Singapore government. [8]

(a) Explain why low inflation is an important macroeconomic aim of the Singapore government. [8]

Inflation is defined as a sustained and persistent increase in the general price level. There are different possible causes of inflation, such as demand-pull or cost-push inflation. According to economists, a generally low inflation rate of 2 to 3% is optimal for an economy; however, hyperinflation results in adverse internal and external effects on an economy. Therefore, price stability is considered one of the important, major macroeconomic aims of any government, and Singapore is not an exception.

Internal Effects

There are adverse internal effects on an economy due to inflation. First, there could be an increase in “menu costs” as businesses would have to change price lists on their menus and catalogues often when inflation occurs, therefore incurring high transaction costs. Inflation could also result in “shoe-leather costs”, for instance, when firms frequently move money in and out of financial institutions to get the highest possible returns. Hence, high transaction costs could be an internal problem generated by inflation.

Secondly, inflation could also lead to a redistribution of income. Fixed income earners would suffer as the real value of their income would decrease due to inflation. For instance, pensioners or people on fixed wages would suffer due to inflation as their incomes would be able to buy less goods and services. Variable income earners, such as insurance agents or property agents, might not suffer that much because their incomes could increase due to inflation. Simultaneously, inflation would reduce the real value of debt. Hence, debtors would gain while creditors would lose in terms of purchasing power. The amount of the debt repaid by the borrower would have a smaller purchasing power due to inflation. Hence, a redistribution of income in favour of variable wage earners and debtors would occur.

Third, inflation damages investment. This is because the real value of savings will fall and people might be inclined to consume and spend instead of saving. This fall in savings would reduce the amount of funds available for investment, hence increasing borrowing costs (interest rates would rise as a result). Inflation also creates uncertainty as it is difficult for businesses to predict costs and revenues, profits, and losses. This would lead to a fall in investment, which would limit the future economic growth of the economy as well as the productive capacity of the country.

External Effects

When it comes to the foreign sector, inflation also has adverse effects. Inflation could negatively affect the competitiveness of a country’s exports. With higher inflation, a country’s exports would become relatively more expensive compared to goods from other countries. Assuming that the demand for Singapore’s exports is price-elastic, this would mean a larger than proportionate fall in the quantity demanded of exports when Singapore’s exports are priced higher relative to other countries due to the effects of inflation. Furthermore, with a higher relative rate of inflation as compared to other countries, this would mean that domestically-produced goods are relatively more expensive as compared to imports. Consumers would then switch from locally-produced goods to purchasing imports instead, assuming these are close substitutes. Therefore, import expenditure would also increase.

The Balance of Payments (BOP) would therefore be affected. For a small and open economy like Singapore, which depends on exports to drive economic growth, inflation could greatly worsen the country’s current account and thus worsen the BOP, assuming the capital/financial account remains unchanged. As a small economy with no natural resources, Singapore is dependent on imports of raw materials. Therefore, this makes Singapore susceptible to imported inflation, where the rising prices of such imports would lead to a higher cost of production, hence leading to a spiral of higher prices. Due to the high import content of Singapore’s exports, this could lead to a higher price of Singapore’s exports, hence adversely affecting export competitiveness.

Conclusion

In conclusion, the higher the rate of inflation, the greater the adverse effects on the country, be it internal or external effects. There are many different policies that the Singapore government can potentially use to curb inflation, such as fiscal policy, monetary policy, and supply-side policies.

JC Economics Essays: Tutor's Comments - This is part (a) of a two part Economics examination question set by an Economics tutor who was one of my classmates at NIE (National Institute of Education), where we did the PGDE (Postgrad Diploma in Education) for Economics. She kindly allowed me to modify her essay to fit this post. However, despite the fact this Economics essay was written by an Economics tutor, under simulated examination conditions, the question still remains: how can I improve on this work? Now, try a little more "feeling-based" or even "emotion-based" questions - what do I feel is correct about this Economics paper? what do I feel is right about this paper? is it just right in length? does it address the question? and so on. You can get a right gut feel about an Economics paper if you have reviewed many related Economics questions and gotten a feel of what a correct answer will or should look like. On my Economics site here, I have many other related questions - do explore them and see the comments that I have given to my students, other fellow Economics tutors, and to professional Economics paper writers. Thanks for reading and cheers! 

“Governments should focus primarily on a low and stable rate of inflation.” Discuss. [15]

(b) “Governments should focus primarily on a low and stable rate of inflation.” Discuss. [15]

This essay discusses the macroeconomic aims of governments. This essay argues that, while low inflation is an important macroeconomic aim, governments should also focus equally on other macroeconomic aims such as low unemployment, economic growth, and a stable balance of payments. There are a few types of policies that governments can use to achieve their aims. First, monetary policy is the manipulation of monetary variables such as money supply, interest rate and the exchange rate. Second, fiscal policy refers to the use of government spending and taxation to achieve macroeconomic objectives. However, other than such demand-side policies, governments can also use supply-side policies, which increase the quantity and quality of resources, and improving technology.

Targeting Inflation

First and foremost, clearly there are good reasons for governments to use demand-management or supply-side policies to tackle inflation. This is because a persistent and sustained increase in the general price level hurts fixed-income wage earners and retirees on pensions, as well as consumers of goods and services, who find that their incomes buy fewer goods and services. Inflation reduces the real value of their incomes. In addition, inflation makes it difficult for trading and exchanges within an economy, for instance due to menu costs – the costs of constantly updating prices. Furthermore, inflation makes it difficult for a country to engage in international trade. This is because cost-push inflation reduces the competitiveness of a country that depends on exports, for instance, Singapore, which might suffer from imported inflation. These culminate in a wider socio-political impact: for instance, the hyperinflation in Weimar Germany in 1923 led to socio-political unrest and the collapse of the Weimar government.

Targeting Unemployment

Yet, inflation is not the main goal or the only focus of government policies. Another important goal of government can be to increase employment, or lower unemployment. Unemployment refers to the situation where people able and willing to work are unable to find jobs, and can be structural, demand-deficient, frictional, or seasonal. Being unemployed causes financial hardships for citizens, therefore governments have to ensure that there is job creation for citizens. For example, during 2008-2010, in the depths of the financial crisis and economic recession, there was massive unemployment in many developed economies, especially in the West. Governments can also tackle structural, frictional, and seasonal unemployment by focusing on these problems rather than concentrating their efforts on inflation.

In fact, reducing inflation sometimes leads to increased unemployment. This is because if the inflation comes from demand pressures, policies that lower AD might inadvertently cause demand-deficient unemployment. In a similar vein, focusing on solving unemployment might lead to higher inflation. This is because of government failure – governments do not always know where the AD and AS curves of the economy are, and their actions suffer from time lags and delays, due to imperfect information. If governments use demand side policies such as Keynesian fiscal policy, and the economy is near the full employment level, then an overshooting AD might lead to inflation. Therefore, there is a trade-off between inflation and unemployment.

Targeting Economic Growth

Another goal of government can be to raise economic growth, which leads to a rise of the standards of living in a country, which will generally make citizens better off. Economic growth is measured by percentage increases in real Gross Domestic Product (GDP), which measures the production of an economy. Generally, a higher real GDP per capita means a higher standard of living for the people of that country. There are two aspects to growth: actual growth measures the rate of change in the volume of output produced within the country in a year, and increases mean increased employment, another of the government’s goals. Potential growth is the percentage annual increase in the economy’s capacity to produce. Economic growth can be increased via increasing aggregate demand and increasing aggregate supply. Thus, the government may introduce demand management policies, such as monetary and fiscal policy, as well as supply-side policies in order to aid actual and potential economic growth respectively. Supply-side policies generally lower inflation by shifting LRAS to the right, and therefore it would seem that there is no trade-off.

However, increasing actual economic growth sometimes results in more inflation, because the AD shifts rightwards, and there might be a trade-off to be made between economic growth and a low rate of inflation; higher rates of economic growth are generally accompanied by higher rates of inflation, ceteris paribus.

Targeting the BOP

Another possible macroeconomic aim of government is to maintain a balance of payments (BOP) surplus. Generally, some governments like Singapore run BOP surpluses for most years, where export values exceed import values. For example, Asian countries such as China have been running huge BOP surpluses, vis-à-vis their trading counterparts, mainly western countries; they have been selling more exports than imports they buy, and this provides a net inflow of capital into their countries rather than an outflow.

However, running a current account surplus might lead to demand-pull inflation because exports (X) exceed imports (M), if the economy is already near or at the full employment level. Therefore there is a trade-off decision to be made between a current account surplus and demand-pull inflation.

Conclusions

In conclusion, one disagrees with the statement posed. All the macroeconomic aims of government are important and the government has to maintain a balancing act, considering various trade-offs. Also, governments may have to tackle different problems at different time periods, and thus inflation should not be the primary focus. In the final analysis, governments should use a combination of demand-management and supply-side policies to manage society’s macroeconomic aims, and not merely focus primarily on inflation, because it is one problem among many.

JC Economics Essay - Tutor's Comments: This is the second part to a question on inflation. There are many relevant real life examples in this essay, and this "A" grade essay also tackles a wide range of macroeconomic aims and  policies, which makes it a balanced, sound, and well-written Economics paper. In addition, the conclusion is considered, evaluative, and generally quite interesting to read. Overall, it is very well done! However, the usual question applies: if you were an Economics tutor, what would you do to make this Economics paper better? How would you improve on it? To take a specific case: if you were going to edit or correct the conclusion, what better conclusion, or what alternative conclusion to this Economics essay could you come up with? Think, think, think; thanks for reading and cheers!

What can a government do to increase economic growth? Discuss. [25] (Second Version, Revised)

What can a government do to increase economic growth? Discuss. [25]

Note: This essay has appeared before on my site; this is a second version.

What can a government do to increase economic growth? There are many policies a government can utilise to achieve this macroeconomic objective. Economic growth can be measured by percentage increases in real Gross Domestic Product (GDP), and there are two main aspects – actual and potential growth. Actual growth measures the actual rate of change in the volume of output produced within a given country, within a year. Potential growth is the percentage annual increase in the economy’s potential capacity to produce output. Economic growth can be increased via increasing aggregate demand (AD) and increasing aggregate supply (AS), which target actual growth and potential growth respectively.

Thus, this paper suggests that a government may introduce demand-management policies, such as monetary and fiscal policy, which target actual growth, as well as supply-side policies, which target potential growth, in order to increase economic growth.

Demand-Management Policies

First, a government can use expansionary demand-management policies. Monetary policy is the manipulation of monetary variables such as money supply, interest rates, and even the exchange rate (for example in Singapore’s case) to achieve macroeconomic policy objectives such as steady, sustained economic growth, low and stable inflation, a healthy Balance of Payments (BOP) and full employment. Expansionary monetary policy may be employed to promote economic growth. It involves reducing interest rates, where the reduction of interest rates leads to an increase in consumption spending (C) or firms’ investments (I), thus raising AD, or reducing the external value of the currency which makes a country’s exports look relatively cheaper, thus boosting export sales. A reduction in interest rates will increase consumer spending on consumer durables and may encourage spending at the expense of savings. A lowered interest rate will also encourage investment. As AD is made up of C + I + G + (X-M), (G means government spending and (X-M) means net exports), hence, when both C and I increase, AD shifts to the right. A lower cost of borrowing will increase the incentive for investment as now the returns would be greater. The increase in both consumption expenditure (C) and investment expenditure (I) will cause AD to rise and thus, promote actual growth.

In terms of exchange rate policy, devaluation or depreciation in the exchange rate is often used by governments of open economies that operate a fixed exchange rate system or a managed float system. By devaluing their domestic currency, a country would be more export competitive as their exports will appear to be cheaper relative to other countries. Assuming the Marshall-Lerner condition is satisfied, net exports as well as AD will rise. This, in turn, will cause output and employment to increase.

Fiscal policy refers to the use of government spending and taxation to achieve macroeconomic objectives. To promote economic growth, to boost output and to increase employment, a government can also employ an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes (t). An increase in G will cause an increase in aggregate demand directly since AD = C + I + G + (X-M). A reduction in personal income tax would raise consumption as it would further increase the disposable income of households and thus their ability to spend. Moreover, a decrease in corporate tax will increase profits and hence raise the level of investment in the economy. An expansionary fiscal policy thus raises AD, and hence output and employment, and thus promotes actual growth.

Supply-Side Policies

Secondly, and on the other hand, to promote potential growth, the government may adopt supply-side policies. Supply-side policies are designed to shift the AS curve to the right by increasing the quantity and quality of resources via improving the efficiency in product and labour markets, and also by improving the level of technology.

A reduction in labour market rigidities can be carried out via provision of education and training, reduction in direct taxes, cut in unemployment benefits, reforming trade unions, and wages and prices policies. Education and training can raise labour productivity and mobility and thus increase productive potential of the country. Labour productivity or the efficiency of labour is measured by output per hour worked. Reducing personal income tax and corporate tax rates can raise the productive capacity of a country by increasing the quantity and quality of labour and capital available to a country. A lower income tax rate would create incentive for work as now there is as expansion in the amount of disposable income. A lower corporate tax rate would also increase investment as businessmen would be able to keep a larger share of profits. The cut in unemployment benefits will also increase the incentive to work as the unemployed would be disadvantaged if they are not engaged in productive labour. The power of trade unions can also be reduced by the government as this would result in a reduction of wages of labour. This, in turn, will increase employment, labour markets flexibility and efficiency. Thus, if labour costs to employers are reduced, their profits will probably rise. This would encourage and enable more investment and economic growth.

Pro-business policies are designed to promote greater private investments in the country. These include building world-class infrastructure, investing in R&D and tax reforms to ensure greater compatibility with international trends in taxes. The government can also increase AS via the adoption of more pro-competitive policies such as the passing of anti-monopoly laws, removal of barriers to entry to certain regulated industries, eliminating tariffs as well as other restrictions on imports.

Limitations of Policies

However, both aggregate demand and supply side policies have their share of limitations. Reducing interest rates may cause the country’s currency to depreciate as it encourages hot money outflows. A lower exchange rate will make the exports of a country more competitive whereas imports will be dearer. Moreover, if the consumer and business outlook is gloomy, a fall in interest rates may not encourage firms and households to increase borrowing because firms’ profits are falling and consumers may be expecting lower wages and lower year-end bonuses. When the exchange rate is reduced, if the economy is operating near or at full employment, inflation will result. If the demand for exports and imports is price inelastic, net exports and AD will fall. This, in turn, will cause output and employment to fall. Hence, inflation can cancel out the price advantages resulting from a reduction in the external value of the currency.

Fiscal policy may conflict with other macroeconomic goals because if AD increases by too much, economic growth will be achieved at the cost of demand-pull inflation. Also, if the government has to borrow in order to increase spending, it may result in a BOP deficit. The decrease in tax rates may not bring about the desired increase in consumption and investment if households and businesses are pessimistic about future prospects. Moreover, a cut in personal income tax may induce an increase in the amount that they save rather than spend. The full effects of an expansionary fiscal policy may only be felt after a considerable time period. Thus, its effectiveness may not be realised in the short term.

Supply-side policies such as education and training take time to have an effect and are also very costly. Reducing taxes may encourage some people to work fewer hours so that they can enjoy more leisure. Reducing corporate taxes may result in firms paying higher dividends rather than undertaking more investment. Cutting unemployment benefits would also not guarantee that it would reduce unemployment as jobs are not created and neither are their skills upgraded. It increases the urgency of finding a job. However, it does not increase their capability of getting a job.

Conclusions

Thus, economic growth can be achieved via fiscal policy, monetary policy, supply-side policies as well as by pro-business policies. However, it may be achieved at the expense of the limitations discussed and thus, a combination of policies could result in better economic growth rather than the policies being utilised as standalone measures to improve the economy.

JC Economics Essays – Tutor’s Commentary: This Economics essay on economic growth has appeared before on my site; this is a second version (amended, revised, changed version). One major problem with this Economics essay is that the conclusion is still not evaluative enough. Economics tutors usually lament that their students cannot write excellent evaluations after writing many excellent paragraphs before that. How do you write an evaluative paragraph? One tip that many Economics tutors give is that students should be sure to signpost their essays with phrases such as: “to a large extent, in my opinion, it is likely that, one can argue that”, and so on. Now put yourself back into the shoes of your own Economics lecturer in school, here once again. How would a good Economics tutor make this conclusion here better? Also, which diagrams do you need here, and why? A good Economics tutor would point out that AD/AS would be really useful here: my advice for this piece of work would be – always include a relevant Economics diagram and also write an evaluative conclusion to get the highest, best grades. 

Discuss the effectiveness of government policies that could be used to tackle China’s inflation. [25] (rephrased Economics question)

“In 2003, China achieved an impressive growth rate of about 9%. Domestic consumption and investment formed the dominant source of her growth, and her inflation rate was above 5%. The economy was overheated.”

Adapted from The Straits Times, 2004

Discuss the effectiveness of government policies that could be used to deal with China’s ‘overheated economy’. [25]

Introduction

China is facing massive demand-pull inflation because of her rapid actual economic growth in recent years. Inflation can be defined as a persistent and sustained increase in the general price level, and can be classified as demand-pull or cost-push. In the context of China, because domestic consumption and investment forms the dominant source of China’s actual economic growth, the likely cause of China’s “overheated economy” is demand-pull inflation, which has to be countered using either demand-management or supply-side policies, or a combination of such measures by the Chinese government. This paper discusses contractionary demand-management policies, such as fiscal and monetary policies, and supply-side policies, in China’s context, and discusses the effectiveness of the suggested policies.

Demand-Pull Inflation

Insert Economics diagram here. What Economics diagram should go here?

In the diagram above, it is clear that increases in consumption (C) and investment (I) have led aggregate demand (AD) to shift to the right, which constitutes in this case actual economic growth, and thus inflation has resulted because the economy is near the full employment level. With a burgeoning middle class in China wanting to spend on consumer goods and other luxuries, and with domestic and foreign firms wanting to capitalise on the rising middle class in China, there has been a huge increase in AD. These collectively lead to demand-pull inflation because AD = C + I + G + (X-M), and therefore there is a need for the Chinese government to utilise either contractionary demand-management policies or increase the AS through supply-side policies.

Effectiveness of Government Policies

In the short run, contractionary demand management policies such as fiscal policy, monetary policy, or exchange rate policy can be used, to shift AD to the left and thus reduce inflationary pressures. In the longer term, supply-side policies can be used to increase the AS and thus reduce inflationary pressures.

What is the effectiveness of demand-side policies in China’s context? First and foremost, it is clear that any contractionary demand-side policy will reduce AD and tackle the problem directly. For instance, fiscal policy dictates that government spending should be reduced or taxes raised, and this would shift AD to the left, ameliorating inflationary pressures. Monetary policy used in this context would raise interest rates, reducing C and I because borrowing costs have increased, and therefore AD would also shift to the left. Appreciating the currency or revaluing the country’s currency would make exports look relatively expensive whilst imports look relatively cheaper, thus shifting AD to the left as well, directly addressing demand-pull inflation. In China’s case, a combination of fiscal policy and revaluation would make sense by reducing AD, directly addressing the issue.

What is the effectiveness of supply-side policies in China’s context? There are many supply-side measures that can be taken, for instance improving the efficiency of the labour market, via reducing frictional unemployment; increasing human capital training and development via training, retraining, and upgrading; and increasing labour productivity through capital and technological increases. These measures would be effective in the long run when AS shifts to the right and thus reduces the general price level in the intermediate and long term.

Ineffectiveness of Government Policies

On the other hand, the Chinese government has to be aware of possible limitations of such policies. First, contractionary fiscal policy might lead to unemployment and political problems if Chinese State Owned Enterprises laid off staff or if military spending were to be cut. Rising income taxes could hinder productivity and labour incentives because people might not work as hard. Corporate taxes, when raised, might affect the profitability of firms. These might lead to unemployment or lower actual economic growth.

Secondly, monetary policy could be highly ineffective in China’s case. This could be due to a variety of reasons. First, if business confidence is high, increasing interest rates would not dampen consumption and investment much. Secondly, China operates a fixed exchange rate and therefore the economic “trilemma” should apply to China. According to theory, a country cannot have free flowing capital, a fixed exchange rate, and yet pursue monetary policy using interest rates, because of the impossible economic “trilemma”. Thus, it is more likely that China uses exchange rate policy rather than depending mainly on interest rates.

Thirdly, supply-side policies operate in the long run but inflation affects China now. Furthermore, supply-side policies operate indirectly rather than tackling the root of the problem which is demand-pull inflation, which affects AD. Also, the Chinese government would have to invest in costly, expensive, and difficult long-term training, retraining, and upgrading for the workforce, and all this spending would have opportunity costs in terms of healthcare, defence, and education.

Conclusions

In conclusion, the Chinese government can use fiscal, monetary, or exchange rate policies in conjunction with longer term supply-side policies to tackle demand-pull inflation. However, multiple management policies would probably have to be implemented in order to successfully counteract the “overheated economy”. Also, there are trade-offs in that an excessive handling of inflation could lead to unemployment and slower actual economic growth, and governments should be aware of the trade-offs and their implications.

JC Economics Essays – Tutor's Commentary: The above Economics essay is on the interesting and current topic of inflation in China and government macroeconomic policies that could tackle this inflation. Instead of me telling you the grade that this paper would get – instead, let’s do another thinking exercise. Put yourself into the role of an Economics examiner looking at this piece of work. Once again, think about how your Economics tutors in Junior College, or university, for that matter, would rate this essay. Try to put yourself into your Economics tutor’s shoes. What would he or she say, and why? Also, try another exercise: try to draw out the diagram that would have been in this post if I had been less of a luddite and more of a techie. What would the diagram be, and why? Hint: you might want to use an AD-AS diagram - how would it look like? Thanks for reading and cheers. 

(b) What can the government do to increase Economic Growth? [15]

(b) What can the government do to increase Economic Growth? [15]

There are many policies a government could undertake to increase economic growth. Economic growth is measured by percentage increase in real Gross Domestic Product (GDP). There are two main aspects to economic growth. Actual and potential growth. Actual growth (AG) measures the rate of change in the volume of output produced within the country in a year. Potential growth (PG) is the percentage annual increase in the economy’s capacity to produce. Economic growth can be increased via increasing aggregate demand and increasing aggregate supply. Thus, the government may introduce demand management policies, such as monetary and fiscal policy as well as supply-side policies in order to aid economic growth.

Monetary policy is the manipulation of monetary variables such as money supply, interest rate and the exchange rate to achieve macroeconomic policy objectives such as steady and sustained economic growth, low and stable inflation, a healthy Balance of Payment (BOP) and full employment. Expansionary Monetary Policy may be employed to promote economic growth. It involves, raising monetary supply, reducing interest rates (as seen from Figure 1 - think of WHAT diagram and HOW to draw the diagram) where the reduction of interest rates leads to an increased supply of goods or reducing the external value of the currency. A reduction in interest rates will increase consumer spending on consumer durables. It may also encourage spending at the expense of saving. It also increases the amount available to spend after people have paid less for loans with low interest rates. A lowered interest rate will also encourage investment. This is shown in Figure 2 as AD0 increases to AD1 as AD is made up of C + I + G + (X-M). Hence, when C and I increase, AD shifts to the right. A lower cost of borrowing will increase the incentive for investment as now the returns would be greater. The increase in both consumption expenditure (C) and investment expenditure (I) will cause the AD to rise and thus, promote actual growth. A reduction in exchange rate is often used by governments of open economies that operate a fixed exchange rate system. By depreciating their domestic currency, a country would be more export competitive as their exports to other countries will be cheaper. Assuming the Marshall-Lerner condition is satisfied, net exports as well as AD will rise. This, in turn, will cause output and employment to increase.

Fiscal policy refers to the use of government spending and taxation to achieve the macroeconomic objectives. To promote economic growth, boost output and employment, a government can also employ an expansionary fiscal policy. With reference to Figure 3, the economy initially operates at A which is below the full employment level Yf. The government could adopt an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes. An increase in G will cause an increase in aggregate demand directly since AD = C + I + G + (X-M). A reduction in personal income tax would raise consumption as it would further increase the disposable income of households and thus their ability to spend. Moreover, a decrease in corporate tax will increase profits and hence raise the level of investment in the economy. An expansionary fiscal policy thus raises AD and hence, output, employment and thus promotes actual growth.

To promote potential growth, the government may adopt supply-side policies. Supply-side policies are designed to shift the AS curve to the right by increasing the quantity and quality of resources via improving the efficiency in product and labour markets, and also by improving the level of technology. A reduction in labour market rigidities can be carried out via provision of education and training, reduction in direct taxes, cut in unemployment benefits, reforming trade unions and wage and price policies. Education and training can raise labour productivity and mobility and thus increase productive potential of the country. Labour productivity or the efficiency of labour is measured by output per hour worked. Reducing personal income tax and corporate tax rates can raise the productive capacity of a country by increasing the quantity and quality of labour and capital available to a country. A lower income tax rate would create incentive for work as now there is as expansion in the amount of disposable income. A lower corporate tax rate would also increase investment as the businessmen would be able to keep a larger share of profits. The cut in unemployment benefits will also increase the incentive to work as the unemployed would be disadvantaged if they are not engaged in productive labour. The power of trade unions can also be reduced by the government as this would result in a reduction of wages of labour. This, in turn, will increase employment, labour markets flexibility and efficiency. Thus, if labour costs to employers are reduced, their profits will probably rise. This would encourage and enable more investment and economic growth.

Pro-business policies are designed to promote greater private investments in the country. These include building world-class infrastructure, investing in R&D and tax reforms to ensure greater compatibility with international trends in taxes. The government can also increase Aggregate Supply via the adoption of more pro-competitive policies such as the passing of anti-monopoly laws, removal of barriers to entry to certain regulated industries, eliminating tariffs as well as other restrictions on imports.

However, both demand and supply side policies have their share of limitations. Reducing interest rates may cause the country’s currency to depreciate as it encourages hot money outflows. A lower exchange rate will make the exports of a country more competitive whereas imports will be dearer. Moreover, if consumer and business outlook is gloomy, a fall in interest rate may not encourage firms and households to increase borrowing because firms’ profits are falling and consumers may be expecting lower wages and lower year-end bonuses. When exchange rate is reduced, if the economy is operating near or at full employment, inflation will result. If the demand for exports and imports is price inelastic, net exports and AD will fall. This, in turn, will cause output and employment to fall. Hence, inflation can annul the price advantage resulting from a reduction in the external value of the currency. Fiscal policy may conflict with other macroeconomic goals as if AD increases by too much; economic growth will be achieved at the cost of inflation. Also, if the government has to borrow in order to increase spending, it may result in a BOP deficit. The decrease in tax rates may not bring about the desired increase in consumption and investment if households and businesses are pessimistic about future prospects. Moreover, a cut in personal income tax may induce an increase in the amount that they save rather than spend. The full effects of an expansionary fiscal policy may only be felt after a considerable time period. Thus, its effectiveness may not be realised in the short term. Supply-side policies such as education and training take time to have an effect and are also very costly. Reducing taxes may encourage some people to work fewer hours so that they can enjoy more leisure. Reducing corporate taxes may result in firms paying higher dividends rather than undertaking more investment. Cutting unemployment benefits would also not guarantee that it would reduce unemployment as jobs are not created and neither are their skills upgraded. It increases the urgency of finding a job. However, it does not increase their capability of getting a job.

Thus, economic growth ca be achieved via Fiscal Policy, Monetary Policy, Supply-side policies as well as by pro-business policies. However, it may be achieved at the expense of the limitations named above and thus, a combination of the policies could result in better economic growth rather than them being utilised as a stand alone measures to improve the economy.

JC Economics Essays: Tutor's Comments: A very well written essay, which was composed under examination conditions. Total Marks: 20.5/25. 

Further Economics tutor's comments: think of how you could work on this Economics paper to make it better, tighter, clearer, or worth more marks. Also, think of how the conclusion could be made more evaluative, interesting, and readable. Do think of how to draw the relevant and proper Economics diagrams for this essay as well. Thanks for reading and cheers!

(a) What can the government do to reduce unemployment? (10)

(a) What can the government do to reduce unemployment? (10)

The unemployed refers to the people in the working population who are available for work and are actively looking for a job but cannot fid a job. The unemployment rate can be measured via this formula: Unemployment Rate (%) = {[unemployed ÷ (employed + unemployed)] × 100%}. The types of unemployment include demand-deficient unemployment, frictional unemployment, structural unemployment and seasonal unemployment. Thus, in order to reduce demand-deficient unemployment, demand management policies are implemented by the government. To reduce frictional, structural and seasonal unemployment, supply-side policies can be utilised by the government.

An expansionary monetary policy aids in increasing Aggregate Demand (AD) in order for the economy to reach full employment level. With reference to Figure 1, the economy initially operates at A, which is below full employment level Yf. The Central Bank can adopt an expansionary monetary policy. An increase in money supply will lead to a decrease in interest rates. Since, the cost of borrowing is now lower, households and firms will borrow more for consumption and investment. This increase in consumption (C) and investment (I) expenditure will cause an increase in aggregate demand from AE0 to Ae1 as shown in Figure 1 as AE=C+I+G+(X-M). This raises national output form OY1 to OYf and employment via the multiplier process. Hence, expansionary monetary policy brings the economy to full employment.An expansionary fiscal policy also aids in increasing Aggregate Demand (AD). With reference to Figure 2, the economy initially operates at A which is below the full employment level Yf. The government could adopt an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes. An increase in G will cause an increase in aggregate demand directly since AD= C + I + G + (X-M). Alternatively, the government can also reduce taxes. For example, if the government can also reduce taxes. For example, if the government reduces corporate tax rates, investment (I) would increase and thus cause an increase in AD. The increase in AD as shown from AD0 to AD1 in Figure 2 will raise national output from Y0 to Yf. Hence, employment will also increase and the economy is at full employment.

However, expansionary monetary policy and fiscal policy may be ineffective due to certain reasons. Expansionary monetary policy may be ineffective if consumption (C) and investment (I) are interest elastic. In times of severe recession, even though interest rates are attractive, businessmen may not invest due to the gloomy business outlook. Inflation may also result in both cases when the increase in AD overshoots.

Supply-side policies that the government can adopt to reduce unemployment include reducing labour market rigidities as well as establishing pro-business policies. With reference to Figure 3, the economy initially operates at the level of Y0, which is at the full employment level. There is equilibrium unemployment. The supply-side policy aids to increase the labour market flexibility. The increase in aggregate supply from AS0 to AS1 as shown in Figure 3 will raise the national output from 0Y0 to 0Y1 without an increase in GPL. Hence, employment will also increase.

To solve search unemployment, better job information can be provided via mass media and job agencies. This would thus enable unemployment to decrease as the unemployed workers will be matched to jobs that suit their capabilities effectively. By also providing more education and opportunities to upgrade the skills of workers, it increases the employability of workers by equipping workers with the relevant skills to switch between jobs. Moreover, pro-business policies such as tax holidays for companies and having a good infrastructure would reduce unemployment as other firms would find the host country attractive and thus increases employment. However, supply-side policies are costly, have large time-lags and have unpredictable outcomes.

Thus, in conclusion, a combination of demand and supply-side policies can be used in order to reduce unemployment. Thus, when aggregate demand rises by too much, aggregate supply can also be increased to effectively curb the onset of inflation. And, also, when AS increases by too much, AD can also be increased to curb unemployment.

JC Economics Essays: Tutors/ Examiner's Comments: Good! Well-written paper that addresses the question requirements. 9/10