Sunday, October 12, 2008

How Effective Is Demand Management Policies To Avoid Another Great Depression In US?

What are demand management policies?

Policies to influence the movement of aggregate demand (AD) & therefore overall level of economic activity. Here we meant the fiscal policy & the monetary policy. Fiscal policy involves the manipulation of government expenditure & level of taxation, while monetary policy involves manipulation of the interest rates & also the money supply

How does fiscal policy work to reverse recession (or worse depression)?

(1) Increase government spending. The government should spend more money onto public works such as transportations, infrastructure, health & education sector, communication etc. Direct government spending (G) moves AD to the right. Along the way, more contractors will be engaged to construct all these. Here it positively affects investment by firms (I). Don’t forget that massive spending will help to reduce unemployment in the economy. As more people are employed, consumption (C) will increase. The latter two will also cause AD to shift rightwards.

As real GDP increase, it will help the economy to rebound. Spending onto infrastructures does have positive supply side effects too as it increase the productive capacity of the economy. It is argued that in the long run, economic growth will be much larger

(2) Slashing tax. Reducing income tax will help to boost the economy via two channels. First, paying lesser tax automatically means an individual having higher disposable income. This helps to increase (C) & therefore pushing AD to the right. From supply side argument, lower tax will increase the incentives to work harder & longer hours as bulk of the income belongs to that individual. AS curve will shift rightwards. The same argument goes for corporation tax. Increase in I will positively affect AD & AS

How does monetary policy work to reverse recession (or worse depression)?

(1) Lower interest rates. Interest rates cut, means borrower paying lesser to the bank & therefore having higher income for other forms of consumption. Also lower rates will induce people to spend into the economy by the way of credit. This is what the Fed did during the Greenspan regime that went on until somewhere in 2005. As a result, the economic boom then after the dotcom burst & terrorist attack took place due to higher household spending. AD increase

The same argument goes for private firms spending. Financing projects & expanding business will be cheap & feasible. More will be expected to take it up. Increase in I will lead to increase in AD too

Lower interest rates will cause US dollar to depreciate. As such, buying from US will be cheaper & this will boost its export market. X increase. To Americans, falling dollar means fall in purchasing power. This discourages imports. M fall. Net effect will be increase in net export (X-M). More foreigners will spend money into US causing economic growth


(1) G is not on public works. It could be a little bit too late for US officials to realise that they should follow the movement of UK government. There is difference between UK & US bailout. In UK, government spends monies to recapitalise the banking system & to improve the balance sheet of the bank with the hope that they are able to lend money as usual. In US, monies are spent on buying toxic debts that nobody wants.

It is a big waste as that huge sum of monies could be better off spent elsewhere especially to redeveloping the economy & generates employment opportunities for those retrenched from the private sector

(2) Little space for G in the future. US’ debt is already ballooning at 70% of their GDP. If were to include those pension funds, social insurance etc, national debt would tantamount to 400% of GDP. It will be a painful procedure to be President Bush’s successor. There is very little space to manipulate G in the future, & most of the task I firmly believe would be focusing on reducing the burden of debt, something we last seen under the administration of Clinton

(3) Tax should not be increased. I believe this is the largest factor that hinders the success of both monetary policy & fiscal policy. Fear over job losses is gripping all Americans (last week itself, more than 160, 000 job losses were reported). Level of wealth gone down together with the falling value of houses & stock prices. Those who were lucky, still hang on to their job perhaps with pay cut & no increment. Increasing tax is killing the man on the street! This is countering expansionary fiscal policy

(4) Interest rate cuts is futile without consumer confidence. With the ongoing credit crisis, banks are more reluctant to co-operate with the Fed. Lower interest rates were not passed on. Also banks are now more stringent in lending. Number of loans approved dropped drastically. Consumers on the other hand, are fearful on taking financial commitments over the insecurity of their jobs. Firms do not borrow over insecurity of future profits. All these lead to fall in C & I.

To worsen the C & I, Dow Jones fell for 7th consecutive day of trading. This shows one thing, if consumer confidence is not restored, NOTHING the government or the Fed do will prevent us from witnessing another onslaught of October 29, 1929 Great Depression (we are now in October too)

Besides, how low can it go? Fed rate is now standing at 1.5%. The depression in Japan throughout 1990s to early 2000s is good evidence. Even though interest rates was 0%, still people & firms are reluctant to spend.

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