Question
Assume that the country is in a period of high unemployment, interest rates are at almost zero, inflation is about 2% per year, and GDP growth is less than 2% per year. Suggest how fiscal and monetary policy can move those numbers to an acceptable level keeping inflation the same. What is the first action you would take as the president? As the chairman of the Fed? Why? What would be your subsequent steps?
Answer
Analyzing the given data indicates us that this economy is suffering from the deflation. In another word, we see high unemployment, very low inflation and very low interest rates. As we know from the theory of investment, when the interest is low, then we expect the investment expenditures to be high. However, we see that there is a high unemployment and very low inflation. That means there is not enough investment in the economy. The agents in the economy do not expect positive signs for the future; therefore, they decrease their investment and consumption expenditures. Consequently, we face the statistics given in the question.
However, increasing the money supply in the economy will cause inflation. Inflation is not the main disturbance in this economy. We might allow the inflation to go up a little in the short run. But in the long term we would not like to face a high inflation. However, if increasing the prices can stimulate the producers, then the income level in the economy is expected to rise. The income increase will be able to increase the aggregate demand. The higher demand means more production in the economy. If this circle works in the economy, then we might not need to intervene the economy to keep the inflation level low. Because if the inflation is corresponded by an increase in the production (and the income), then the inflation will stay low without intervention. If the inflation keep increasing in the medium or in the long term, then we might need to intervene the economy to decrease the inflation. Let us say, the income causes a very high increase in the demand, then the economy might not be able to produce enough. Then the higher demand than the supply in the economy might cause a higher inflation. In this case, we need to cut the demand down. The best way to do is to implement contractionary fiscal policies. We can increase the tax rates on the goods and the services highly demanded in the economy. Therefore, we can decrease the demand for this products and the inflation goes down.
A little high inflation in the economy will stimulate the economy; therefore, the unemployment will decrease in the short run. As known, that means the idea of the Philips Curve will work in the economy. The Philips curve basically tells us that there is negative correlation between unemployment and inflation in the short run. However, we need to evaluate the situation in the long run as well. In the long run the Philips curve becomes flat. Because there is no relation between inflation and unemployment in the long run. In the long run, the production amount influences the unemployment. In another word, if the economy is using its production capacity then we do not face unemployment problem. Consequently, if stimulating the economy through using the expansionary monetary policy works, then we will see lower level of unemployment in the short run and in the long run. Because the production efficiency is increasing in the long run, we will not face inflation or unemployment problem in the long run.
The president and the FED can stimulate or slowdown the economy. The president can make the decision to implement the fiscal policies. The FED can implement the monetary policy. The president, to stimulate the economy, can increase the government spending and decrease the tax rates. However, an expansionary fiscal policy might create future troubles for the government. As known, the government’s income is tax and the government finances its spending through this tax money. If the government spends more than the money it collects, then it needs to pay this budget deficit. If the government keeps continuing the budget deficit in the long term, then the economy gets used to this deficit situation. Also, to finance the budget deficit, the government sells government bonds to the people. In another word, to be able to finance the budget deficit, the government gets loan from the economy. The demand increase for the loans in the economy causes an increase in the interest rate and that might decrease the investments in the economy .This is called crowding-out. Therefore, the government spending and the budget deficit are not desired policies if the expansionary monetary policy is enough to stimulate the economy. The FED, as explained in the previous paragraph, can use the expansionary policy to stimulate the economy by increasing the money supply.
The inflation is an important problem for the economies. However, the more important issue for the economies is the low level of investment and high unemployment. The inflation makes us blind and we might not be able to foresee the future. However, the low level of investment means that the economy is not producing. If an economy is not producing, the low inflation or any other indicator does not mean anything. It is like our body. Inflation is like fever in our body. We do not feel good when we have fever. However, the main problem is not the fever. There is another sickness behind the fever. Thus, the inflation is an indicator of a problem in the economy. The high unemployment and low level of investment is like a body which has a real sickness. If it does not recover from this sickness, it might die.
Stimulating the economy by increasing the money supply in the economy can be the first step to stimulate the economy. The economy management should be able to give the message “the economy is secure and alive for investors, workers, and everybody” to the agents in the economy. To do this, the economy management might continue a little higher inflation policy for a while keeping the interest rates low. The government should not cause any budget deficit. The economy management can take the following steps by observing the indicators of the economy. If not necessary, the fiscal policies should not be implemented. An essential policy that the government might implement is to promote the entrepreneurship. By providing support or incentive for new entrepreneurs might help us stimulate the economy faster without causing any negative side effect.
REFERENCES
Gordon, R. J., and Krenn R. (2010). The End of the Great Depression: VAR Insight on the Roles
of Monetary and Fiscal Policy. Working Paper, No.16380. Cambridge, Mass.: National Bureau of Economic Research.
Elwell, Craig K. (2013). Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis
Economy. Congressional Research Service, CRS Report for Congress.
Barro, R. J., and Redlick, C. J. (2011). Macroeconomic Effects from Government Purchases and
Taxes. Quarterly Journal of Economics, No.126, pp.51–102
