Introduction
Economic management is the most critical function of any government. It requires critical approaches through the adoption of efficient macro-economic policies that lead an economy in the desired direction. Inefficiencies in public policies result in poor economic management, which results in economic problems such as unemployment, inflation, and other forms of economic instabilities (Galí 98). This essay will answer questions that address some of these economic problems.
Government measures to increase the level of aggregate demand in the economy and their effectiveness
The level of aggregate demand is an essential factor in the determination of the economic position of an economy. It determines critical factors such as investment that indicate the GDP of a country (Friedman 11). Thus, the government must adopt effective measures to manage it. The government mainly uses monetary and fiscal policies to regulate the aggregate demand.
Monetary policy entails the management of an economy through the regulation of money supply into the economy (Friedman 11). Interest rates, as well as inflation, are affected by the level of money supply. If the government wants to increase the level of aggregate demand, monetary measures adopted must lower the inflation level and interest rates. Expansionary monetary policies increase the total demand through expansion of business, increase in exports, high consumption, and increase in savings (Friedman 12). Monetary policies are effective to some extent, particularly in the stimulation of aggregate consumption.
Fiscal policy entails the management of economy through the regulation of government expenditure and taxation (Galí 119). Fiscal policy tools can be used to increase the level of aggregate demand. An increase in government spending results in high level of employment leading to increased individual demand. High level of consumer spending due to high employment rate results in the overall rise in total demand in an economy. Additionally, reduced taxation stimulates demand by increasing disposable income (Friedman 14). Fiscal policies are very effective in demand management, but a combination of fiscal and monetary policy is most effective.
Features of monetary policy and how it can be used to manage the economy
Monetary policy can have expansionary or contractionary effects depending on the purpose for adoption of the policy. Monetary policy is normally used to manage the economy through regulation of money supply which affects interest rates as well as inflation (Friedman 12). An expansionary monetary policy stimulates economic growth by reducing interest rates. Low interest rates encourage borrowing and investment. High level of investment results in increased employment, household income, and consumption. As a result, the level of demand increases leading to economic growth.
Regulation of money supply has a significant impact on inflation level. Excess money supply results in demand that exceeds supply, leading to an inflationary situation in an economy (Mankiw 61). The government reduces the amount of money in circulation through the sale treasury bonds in open market operations to correct the situation. Also, the central monetary authority may tighten monetary policy to regulate borrowing by increasing interest rates or through selective credit control. Thus, it helps in maintaining stable economic conditions without inflationary gaps.
Advantages and disadvantages of low interest rates in an economy
Interest rate is one of the tools that governments use in economic management. Interest rates affect economic performance in various ways. Thus, the decision to raise or lower interest rates depends on the situation in the economy and the desired objectives. Low interest rates have both advantages and disadvantages. During an economic depression, low interest rates are essential to stimulate economic recovery (Prasad, para 7). Low interest rates encourage borrowing which increases money circulation in the economy. High level of money in circulation helps to support economic recovery through increased investments which promote economic stimulation. Thus, low interest rate can help to drive an economy out of economic recession.
Low interest rates discourage saving and encourage excess borrowing. According to Prasad, high borrowing rates results in increased money supply in the economy leading to excess demand (Prasad, para 9). People demand more than what producers can supply resulting in price inflation. Also, the level of investment may decline at extremely low interest rates since there are low savings. Additionally, low interest rates tend to affect assets prices as people shift from saving money in banks to investment in other forms of assets. High demand for assets increases their prices leading to an overall decline in investments. Therefore, interest rates should be maintained at levels that support sustained economic growth.
Meaning, measurement, and importance of GDP in economic growth
Gross domestic product refers to total value of products and services produced in an economy in monetary terms. Essentially, GDP represents the total value of output produced within an economy. Three methods are used to measure GDP. These methods include expenditure, output, and income method.
Expenditure method
This approach entails the summation of all types of expenditures on output. These expenditures include government, private investment, consumption, and net spending on international trade. Thus, GDP can be expressed as GDP=C+I+G+ (EXPORTS-IMPORTS), where
C= private consumption
I= private investment
G= Government expenditure
Income approach
The basis of this method is the total income paid to factors of production. It assumes that total spending on factors of production is equal to total income received by the factors. Therefore, GDP is estimated by summing up incomes paid to factors of production and making adjustments to account for depreciation, amount of tax paid, and income earned abroad.
Output method
This approach involves the summation of total output from all sectors of the economy to arrive at the aggregate output. The output from all sectors of the economy such as agriculture, manufacturing, and service are summed up to arrive at GDP value.
Importance of GDP
GPD is an indicator of the overall productive capacity of an economy. The value of GDP is used by the central monetary authorities such as Federal Reserve to manage the economy (Mankiw 58). Additionally, GDP values indicate the wealth of a country which can be used to estimate the income per capita. Thus, it helps to determine the living standards in an economy. Besides, GDP estimates facilitate the decision-making process regarding the allocation of resources in a country.
Causes of inflation and unemployment
Inflation and unemployment are two related terms (Phelps 153). Unemployment represents a situation where a person is able and willing to at the prevailing market wages but cannot find a job. Unemployment and inflation are major economic problems facing many countries particularly developing countries (Friedman 16). Inflation represents a situation in an economy where prices increase persistently. The price increase can result from high demand or high production costs. Thus, inflation exists in forms of demand pull or cost push inflation (Sargent 37).
Demand pull inflation normally result from factors that increase the level of aggregate demand (“Inflation n.p). According to Philips theory, government’s initiatives to reduce inflation through monetary and fiscal policies usually lead to price inflation (Phillips 285). An increase in money supply to stimulate economy results in excess demand leading to inflation. According to Phelps, high inflation rate tends to scare away investors resulting in low level of investment that cause involuntary forms of unemployment in the economy (“Unemployment n.p.).
An expansionary fiscal policy such as an increase in government spending and reduced taxation tend to increase consumers’ disposable income (Friedman 14). As a result, the level of aggregate demand increases above market supply leading to a general increase in prices. On the other, increase in taxes results in high production cost leading to high prices of goods and services. High prices often result in reduced demand for products and services leading to demand deficient forms of unemployment (“Unemployment n.p.). Conclusively, inflation and unemployment often accompany one another. Lack of demand for products due to high prices results in reduced production resulting in low demand for labor. The government uses monetary as well as fiscal policies to control the performance of the economy and to solve major economic problems like inflation and unemployment.
Works Cited
Galí, Jordi. Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. United States: Princeton University Press, 2015. Print.
Friedman, Milton. “The Role of Monetary Policy.” American Economic Review 58.1 (1968): 1–17. Print.
“Inflation - the main causes of inflation | economics.” tutor2u, 2015. Web. 10 May 2016.
Mankiw, Gregory. Macroeconomics. 8th ed. New York: Worth Publishers Inc.,U.S., 2012. Print.
Phelps, Edmund. "The new microeconomics in inflation and employment theory." The American Economic Review 59.2 (1969): 147-160. Print
Phillips, Alban. "The Relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861–19571." economica 25.100 (1958): 283-299. Print
Prasad, Eswar. “How U.S. Interest Rates Influence the World Economy.” 17 Dec. 2015. Web. 10 May 2016.
Sargent, Thomas. The Conquest of American Inflation. United States: Princeton University Press, 2001. Print.
“Unemployment - main causes of unemployment | economics.” tutor2u, 2015. Web. 10 May 2016.
