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!