Government Actions to Encourage Economic Growth
Economic growth is quite fundamental for the success of any nation. The levels of economic growth within a country can be measured by either calculating total output or the total income of the entire population. The rate of growth realized by each individual’s income can be utilized to evaluate the progress of the country over a time. The governments of each country are interested in maintaining a healthy economy by improving the environment for running businesses, and some of the tools that the governments utilize to encourage business activities include interest rates, tax incentives, contracts, loans, and trade policies. Fiscal and monetary policies are the two main methods that the government employ to influence aggregate demand and money supply. This study will focus on how nations can measure economic growth and how fiscal and monetary policies have been useful tools in ensuring economic growth.
Measures of Economic Growth
The economic growth of any country is normally associated with the rising incomes, increase in consumption, rise in savings, as well as investments. The two common tools that economists utilize to measure economic growth in a country are the gross domestic product (GDP) and the gross national income (GNI). GDP measures the total output and income generated within the country’s borders, even though the residents of the country may not receive the entire income that their country generates (Cypher 53). GDP is calculated from the country’s national accounts, where each sector of the country’s economy reports its incomes, expenditure, and investment.
Although GNI is used in measuring production, policy makers use it specifically to measure the country’s welfare. GNI incorporates all incomes that the residents of a country accrue, regardless of the origin of the income. Such income can be obtained within the country or outside the country’s borders. GNI, which is the same as gross national product (GNP) incorporates the GDP and the net primary income coming from abroad (McEachern 449). For instance, the US GNP includes the GDP plus profits earned by US firms, such as Ford and McDonalds, which operate outside the country’s borders. However, income from foreign firms that have established their plants in the US is excluded from the GNI. GNI is calculated by taking the value of final products and services to evade double counting. GNI also utilizes the values of goods and services that are currently produced, hence, does not incorporate the value of used cars or existing houses.
In a closed economy – where only the country’s residents receive the accumulated income while activities that generate such income are within the country’s borders – GDP is equal to GNI. A closed economy, no migration of workers is allowed while foreign investment is strictly forbidden. GDP is the most preferred measure that a country can use to assess its growth because it incorporates all economic activities that happen within the country’s borders. Exports and imports do not have any impact on GDP or GNI because trade flows are not affected by their values. However, the GDP per capita, which is computed by dividing the GDP by the number of people in a country, does not explain how incomes are distributed within the country.
Another measure of economic growth is the human development index (HDI), which focuses on social performance of residents within a country. The weakness in the use of GDP as the appropriate measure of economic growth led to the discovery of the HDI, which determines whether a country is making progress that can ensure sustainability. According to the United Nations Development Program (UNDP), the HDI measures social performance of people in a country using three indicators, which include longevity, education, and the standard of living (Nafziger 34). Each indicator is measure within the range of 0 to 1, where minimum values are perceived as subsistence values while the maximum values hold the highest values depending on the welfare. The income element of HDI constitutes the GNI per capita, which is also indicated in purchasing power parity (PPP) terms (Ray 307). The PPP is quite useful in ensuring that different currencies are used in the process of determining economic growth in each country.
Promoting Economic Growth in Short Run using Fiscal and Monetary Policy
The government has the authority to intervene in the country’s economy to enhance stability. Sometimes the country can experience booms and busts through its business cycle, and the only way to smoothen the curves is through economic policy tools. Fiscal and monetary policies are the two dominant tools that the government can utilize to steer the country into economic growth and stability, particularly during recession. Policy makers can alter the aggregate demand in the short run by increasing government expenditure, reducing taxes, as well as increasing the money supply through offering low interest rates (Sexton 818). This practice will encourage consumption, increase local investment, and create more employment opportunities.
Fiscal policy works when the government exercises its spending and taxing authorities to make changes to the country’s economy. This policy has a direct effect on product markets due to its capacity to increase aggregate output. According to Keynesian economic theories, the government has the powers to affect the economy through increasing aggregate demand. Increased spending by the government enhances money supply, which consequently stimulate the economy through creating jobs and raising living standards of people. When people have enough to spend, demand goes up while companies endeavor to increase production to meet the demand. More people are hired to expand production, leading to low unemployment rates.
An expansionary fiscal policy is utilized to stimulate economy during a business-cycle contraction. A recessionary gap may occur during the contraction, thus, making expansionary fiscal policy the best option to handle it. Fiscal policy involves increase in government spending, a decline in taxes, and a rise in transfer payments. Higher government spending increases aggregate demand, leading to high consumption rates. High consumption rates means consumers are spending their income while businesses are expanding and more jobs are created. Reduction of taxes enhances consumer power to spend what they have earned on goods that they prefer while firms would invest on projects that they anticipate higher profits (Sexton 711). When output increases while more people are employed, the government can collect more revenue, which can be utilized for economic growth.
The classical economists conceptualized that monetary policy is the best tool for attaining economic growth, as well as full employment (Dwivedi 357). The basic assumption of monetary policy is that central banks alter the money supply to create demand or to reduce demand. Understanding the inflation process has been one of the behaviors of the monetary policy. A country can experience economic growth, but the demand for money may surpass the capacity to create such demand, leading to inflationary pressures. In the UK, inflation targets are expressed in terms of annual inflation of retail price index without considering the mortgage interest payments while the Bank of England makes monetary policy decisions every month (Osborn and Sensier 25). Thus, the Bank of England ensures that annual inflation is under control by reviewing monthly data. The Bank of England can raise interest rates to encourage saving and to ease inflationary pressure.
The proponents of Keynesian theory argued that government spending is fundamental in economic growth, thus the resources that the government has to spend should come from the private sector in the form of borrowing or taxation (Mitchell and Debnam 2). They support the government’s action of borrowing money, as well as running deficits in times of economic downturn and pay the debt once the economy starts to show the sign of growth. When economy slows down and employment becomes soft, policy makers can ease monetary policy to enhance aggregate demand. By boosting the aggregate demand to a level above the potential of an economy, slackness will end while employment will regain its vigor. In case of inflationary pressure, the Federal Reserve can tighten the monetary policy through raising interest rates to reduce aggregate demand to enable the economy to return to the path of sustainable expansion.
In short run, prices and wages do not change immediately, hence, a change in money supply can have an effect on real production of goods as well as services. This makes monetary policy become an essential tool for controlling inflation, in addition to attaining growth objectives (Mathai n.p). When prices and wages are inflexible, the monetary policy can only affect real variables in the short run (Wickens 450). Real variables are factors that affect the GDP, and such variables include unemployment and real prices. Lowering interest rates will minimize consumer loan rates, leading to high demand for consumer goods. A drop in interest rates may cause a reduction in dollar value, leading to a boost in the US export market, as the cost of goods from the US will be affordable in foreign markets.
An expansionary monetary policy can be used to tackle the problem of unemployment by increasing money supply to the economy and reducing interest rates. When the Fed allows individuals and corporate to purchase US Treasury securities through the open market, it aims at increasing money supply so that commercial banks can have access to cheaper loans. Consequently, commercial banks are capable of lending money to individuals at a lower interest rate, hence, encouraging investment. A rise in currency demand does not affect money supply, but a change in the reserve ratio has a powerful multiplier effect on the money supply (Stauffer 132).
The use of Laffer curve is an indication that the government can only increase the tax rate to a certain level if it has an intention to increase tax revenue. According to the curve, taxable income declines when tax rates are set to a higher level, which may discourage people from working and investing on what they have earned (Carbaugh 310). If the government has already set high tax rates, it can only increase tax revenue by reducing them to a level that would encourage working. In the 1980s and 90s, the US economy experienced an upward mobility, where the middle-class families’ income rose by about 30% after tax (Moore n.p). The lesson from Reagan administration was that capital and wealth are likely to live in areas where tax rates are relatively low.
Problems of using Fiscal and Monetary Policy Tools in the Long Run
It may not be surprising to state that anticipating policy effects for the future can be a difficult task for the policy makers. The government, the Federal Reserve, or the Bank of England’s job could be quite simple if fiscal or monetary policy effects were swift and guaranteed. According to Baumol and Blinder, economists have discovered that the response of investment in relation to changes in interest rates or tax provision usually takes several years to mature (304). Fiscal policy measures are affected by natural lag, which may result from the delay by the legislature or the executive assent. This makes economic growth quite difficult to predict. Uncertainties may result because the growth in aggregate demand is partly unknown at any given point, and this forces policy makers to rely on estimates when evaluating the best course of action.
When consumers anticipate that the government might increase taxes in the future, they may cut their spending to save for higher taxes in the future. Fiscal policy may result to crowding out, which is the contraction of economic activities due to deficit-financed spending (Mitchell and Debnam 3). Deficit-financed spending induces people to reduce their current spending and save for the future spending. For instance, when the government increases spending on school-feeding program, consumers are likely to cut spending on groceries, and if the government increases its spending on security without raising taxes, the deficit would rise, leading to higher taxes in the future. Crowding out can also result when the government issues bonds through open market at the same time when private firms are also planning to issue bonds.
Expansionary fiscal policy has the capacity to decrease net exports in the long-run, leading to change in national output, as well as income. Expansionary fiscal policy increases the budget deficit, which subsequently compel banks to raise interest rates to compensate such deficit. Government borrowing increases interest rates, which in turn attract foreign capital and foreign investments. Foreign investments lead to appreciation of the country’s currency, which subsequently results to reduced exports as well as an increase in imports.
The dilemma emerges when the two policy tools act as substitute to each other. For instance, when the government raises taxes, or decide to cut on spending, the monetary policy authority may react by reducing interest rates. Any policy that attempts to minimize inflationary pressure or reverse employment losses usually intensifies inflation. Monetary policy makers often encounter a dilemma of whether to neutralize price pressures or cushion the loss of employment. Changes of interest rates in long term can create an effect on stock prices, which consequently affect the household wealth.
Equally, both monetary and fiscal policies have encountered difficulties while trying to tackle supply shock. During the oil price shock, policy makers encounter difficulties while trying to create a balance between high inflation and high levels of unemployment. Some economists have blamed monetary policy for creating liquidity trap, inflation, and asset bubbles (Silvia and Iqbal 23). Liquidity trap occurs when the central banks opt to increase the money supply while people persist in holding money. When interest rates are low and money supply is in plenty, the value of the nation’s currency may decline, thus, reducing the exchange rate. Activist monetary policy may destabilize the economy rather than stabilize because the action of Fed may be too late to create the required stimulus (Arnold 395). In such situation, the stimulus might end up making things worse rather than salvaging the situation. Thus, policy makers should work on ways that would balance the use of both fiscal and monetary policies to enhance economic growth and welfare.
Measuring economic growth of a country involves comparing the total output and income generated within the country’s borders each year. The two common tools that determine the level of economic growth in a country are GDP and GNP. A country that is experiencing economic growth depicts an increase in both GDP and GNP. To promote economic growth and stability, governments use fiscal and monetary policies, which assist in regulating the aggregate demand and money supply in the economy. Fiscal policy enables the government to utilize the revenue collected to influence economic growth through spending while the monetary authority regulates money supply in an economy utilizes monetary policy. Both policies complement each other cushion economy from encountering economic crisis in both short run and long run.
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