The dynamics of the economy when the interest rates are at almost zero are a bit complicated, especially because the monetary policies have very little effect on the economy. However, the interplay between the fiscal and monetary policies will bring the economy to stabilization even though with great difficulty. Some of the factors at play bring a tradeoff between the success and failure of the possible policies. For example, the policies that will bring down the level of unemployment will tend to push up inflation. However, factors that will push the GDP upwards will also lower the rate of unemployment. As a government, the best method in this situation is to employ fiscal policies combined with a few monetary policies.
According to the Philips curve, there is a tradeoff between the rate of unemployment and the rate of inflation. There is no direct relationship between unemployment and interest rates. However, unemployment affects interest rates indirectly since it triggers the government to lower the rate of interest in order to boost investment and consumption, (DeLong, et al. 240). In a normal economy, these actions are always very effective. However, for this case, the economy will not necessarily respond to changes in the rates of interest especially when it’s a fall. At this point, the economy is experiencing a liquidity trap. A liquidity trap is a situation where the rate of interest has fallen too low that investors do not expect it to fall any lower, (Gordon 15). At this point in time, every investor hoards their cash and the fluctuations in the money supply will have very little effect on the prices.
This implies that any attempts by the government to lower the interest rate will have very little effect on the economy. Without the interest rates, monetary policies are often ineffective. This means that an increase in the amount of output will most of the time turn out to be ineffective on the interest rates. Fiscal policies refer to the use of government spending and taxes to manipulate or regulate the conditions in the economy, (Ramey 675). This implies the control of factors such as the rate of inflation, investment, and general consumption. As the president, I would advocate for increased spending immediately and the introduction of tax rebates. The government spending will be focused on non-recurrent expenditure which will limit the spending to the current period. As the president, I will direct the extra spending on development projects and infrastructure maintenance. Depending on the value of the government expenditure multiplier, the increasing the rate of government spending will increase the total output. Also, the tax reduction will increase the amount of output in the economy depending on the tax multiplier.
In mathematical terms, if the government expenditure multiplier is 5, then an increase in government expenditure will increase the output five folds. Similarly, if the tax multiplier is 5, then a reduction in tax rate will increase the output by five times the tax rate. Through the projects, the government will create jobs which will increase the supply of money into the economy. By reducing the rate of taxes, the government will boost investment increasing the rate of production and creating more job opportunities, (Eggertsson 60). This will cater for the problem of unemployment. However, due to the tradeoff between unemployment and inflation, this may raise the rate of inflation. A small rate of inflation is necessary. However, the aim is to maintain the rate of interest at 2%. Therefore, to do this, the government can choose to increase the rate of interest after a short period of time like three months.
As the chairman of the Federal Reserve Bank, my first move will be to reduce the bank minimum deposit rate which will give the banks more money to issue in terms of loans. This is another monetary tool that increases the money supply into the economy. Money supply leads to an increase in spending and investment. In the end, the investment and spending will lead to increase employment reducing the rate of unemployment. Just like the fiscal policies, the increase in money supply will lead to an increase in the rate of inflation which may not be felt immediately. Therefore, this will give the economy a chance to recover before the need to increase the rate of interest. The rise in the rate of interest will boost investment in government bonds and reduce borrowing, thus reducing the money supply, (Davig, and Leeper 215). The disadvantage of using the two methods is that the increased money supply may lead to increased inflation. The costs of inflation will be felt through increase in prices and demand for higher wages. However, with close monitoring, the government and the fed will be able to estimate the point where the inflation starts rising and raise the interest rate in order to prevent any costs of inflation.
Government borrowing implies postponed taxation. Therefore, a deficit economy will have higher risks of inflation and rise in interest rates. It also implies that the government may have to borrow more from the private, meaning the private sector will have little to spend, (Auerbach, and Gorodnichenko 67). This means that in such an economy, increasing the government spending will be very difficult and costly. Thus, I will have to alter the methods used in part one and only resolve to tax rebates as the only feasible means of stimulating the economy. Another method will be the use of foreign investors to invest in the economy. To attract the investors, we may have to offer them unique licenses with long-term tax relieves.
Work Cited:
Ramey, Valerie A. "Can government purchases stimulate the economy?." Journal of Economic Literature 49.3 (2011): 673-685.
Davig, Troy, and Eric M. Leeper. "Monetary–fiscal policy interactions and fiscal stimulus." European Economic Review 55.2 (2011): 211-227.
DeLong, J. Bradford, et al. "Fiscal policy in a depressed economy [with comments and discussion]." Brookings Papers on Economic Activity (2012): 233-297.
Eggertsson, Gauti B. "What fiscal policy is effective at zero interest rates?." NBER Macroeconomics Annual 2010, Volume 25. University of Chicago Press, 2011. 59-112.
Auerbach, Alan J., and Yuriy Gorodnichenko. "Fiscal multipliers in recession and expansion." Fiscal Policy after the Financial crisis. University of Chicago press, 2012. 63-98.
Gordon, Robert J. "The history of the Phillips curve: consensus and bifurcation." Economica 78.309 (2011): 10-50.
Appendices:
Interest figure1.1
i
i 1
i 2
In1 In2 Inflation
Inflation Phillip’s curve
Long run Philips curve
Short run curve
Unemployment
i Normal Liquidity Trap LM
IS
Y
The figures above represent the imaginary relationship between inflation and interest rates, the Philips curve, and the representation of the liquidity trap in an IS-LM Cartesian plane.
