Expansionary Economic Policy Essay Example
Expansionary policy is one of various stabilization policies that can be implemented by government to address economy problems. The Federal Reserve System (Fed) can also stimulate the economy by mechanisms of the expansionary monetary policy. In this paper the main tools of expansionary fiscal and monetary policies are described as well as analyzed main differences between classical and Keynesian theories regarding the aggregate supply and demand connection.
For many years the question on the government’s impact on the general costs level, unemployment and inflation rate is being discussed. Economists that are also called “activists” promote the necessity of a significant role for government, at the same time “nonactivists” believe that government intervention should be avoided. (Keynes and The Classical Economists: The Early Debate on Policy Activism, n.d.) This historical controversy, that has started more than 50 years ago between John Maynard Keynes and the classical economists, now provides a strong platform for understanding government policy.
“Supply creates its own demand” – is the main principle of the classical economists’ theory. This statement was created by French economist J. B. Say. According to this full employment on a principle there was nothing to prevent the economy from expanding to full employment. (Keynes and The Classical Economists: The Early Debate on Policy Activism, n.d.) As long as people are ready to work for a wage that is adequate to their contribution to the output of the firm, employers will hire everyone. In this way the companies produce that can be sold, as everyone has an opportunity to earn enough to be eligible to buy it.
As it is shown on the figure below, according to the classical economists’ theory a reduction in aggregate demand (AD1 to AD2) would cause decreasing of prices and wages, so that will not influence the real GDP neither employment level. At the same time, if the aggregate demand raises (AD1 to AD3) it mays lead to inflation with no change in output.
Figure 1. The Classical Aggregate Supply Curve.
The classical business cycle is part of a decline in aggregate demand, because shifting aggregate demand drives the price level up leaving real output unchanged, therefore any policies targeted at increasing aggregate demand may not be effective. (Amacher & Pate, 2012) Unfortunately, the Great Depression in 1930-s showed, that the classical economists’ doctrine is no longer adequate to the current market situation.
In the middle of XIX century economists noticed that output and employment turnover is different in different periods. Nowadays these ups and downs in the level of economic activity are called the business cycle. Expansion is when the output and employment are increasing and a period of their decrease is called a recession.
“The General Theory of Employment, Interest, and Money” that was published in 1936 by a British economist John Maynard Keynes was recognized as the most powerful critic of the classical model. Arguing classical theory, Keynes stated that companies base their output decisions on the level of expected demand, or expected total spending, thus supply responds to demand but not the converse. According to Keynes the level of total spending in the economy could be inadequate to provide full. (Keynes and The Classical Economists: The Early Debate on Policy Activism, n.d.)
Figure 2. The Keynesian Aggregate Supply Curve.
As per Keynesian theory prices and wages depends on the demand level, as it is shown on the figure above. If demand will decrease (AD1 to AD2) it will cause into lower real GDP and reduced employment. In case people will spend more than the full employment output that will cause inflation without raising real GDP (AD1 to AD3).
Based on the above mentioned theories we may state that government has to participate in the stabilization of the economy. There are many options to regulate aggregate demand and supply. But any actions that are taken whether to support expansionary or contractionary policy come with risks.
Expansionary Policy is one of the options that is used in a low-growth periods in the business cycle. It is a form of fiscal and taxation policy that is called to stimulate the economy, decrease unemployment level and reduce or close a recessionary gap. Within this policy taxes are being decreased and government purchases as well as transfer payments are being increased. This makes money supply higher and therefore people are eligible to spend more, thus business cycle will works more effective. The main risk of such actions is that it may lead to a larger government budget deficit.
One of the expansionary fiscal policy steps is government purchases. It is the amount of goods and services, purchased by the government as part of GDP. These purchases are made by different government agencies. However, frequent additional government purchases can cause to a growth of the government sector.
The second option is taxes - the payments imposed by the government on the rest of the economy. The biggest shape belongs to personal income. Decreasing in taxes provides people (companies and private households) with additional money that are supposed to be spent and return in the business cycle. This will cause higher demand and therefore more labour force will be required. That means that the unemployment level will reduce. Since taxes are variable and easier to implement, they are used more often than government purchases.
One more fiscal policy tool is transfer payments. These are payments made by the government without anything being received in return. Examples of transfer payments would include student scholarship grants, welfare checks, unemployment compensation and social security benefits.
Expansionary fiscal policy is used when the problem of recessionary gap arises. It exists when the economy needs more products than could be produced with the full employment.
Figure 3. Recessionary gap.
On the figure 3 the vertical aggregate supply curve (LRAS) shows full-employment real production. In case the cross of aggregate demand (AD) with short-run aggregate supply curve (SRAS)is lower than LRAS then a recessionary gap occurs. Expansionary policy actions move AD to AD’ and that allows to resolve the gap.
Expansionary Monetary Policy is one more step besides the fiscal policy to regulate economy. The Federal Reserve System can influence on money supply by three main tools reserve ratio, the discount rate and open market operations.
In case the Fed increase reserve ratio, banks will have to put more money on hand at the bank or on deposit with the Federal Reserve District Bank, thus aggregate money supply will decrease. Therefore, in expansionary policy central banks mostly reduce the reserve ratio in order to provide households with more money via banks.
Lowering interest rates will increase investment and create new jobs. That will stimulate business and raise the income and producing level as well as lead to an expansion of GDP.
The discount rate is the rate commercial banks pay to the Fed for short-term loans. These rates are usually higher than the federal funds rate, or the rate that banks pays to each other for the short-term loans. In case the discount rate is high, the price for customer loans is also high. Thus, in order to increase money supply, discount rate should be reduced as that will allow banks to inject more money into economy via loans. This option can be also called ‘fake emission’, as technically, no extra money was issued, but the supply was increased.
Buying and selling government securities (Treasury bills, Treasury notes and Treasury bonds, etc.) by the Fed on the open market is another monetary tool within expansionary policy. In case the Fed buys bonds, bonds are taken out of the economy and money is injected into the economy. (Maitah, M., n.d.) However, when the money supply increases, interest rates fall, as according to ceteris paribus principle.
Borrowers on the other hand should expect or demand a higher interest rate, therefore they will benefit in the end. (Amacher & Pate, 2012)
The issue of government impact on macroeconomic problems provokes many discussions among economists. The classical laissez-faire policy prescriptions were preferred until the time of the Great Depression. Later Keynesian model took leader place. Nowadays the government has many options to regulate economy whenever any business cycle goes down. Expansionary policy presumes increasing money supply level in order to stimulate economy. Among the main government tools are fiscal policy with government purchases, taxation and transfer payments and monetary policy with interest rates, open market operations and reserves. All these actions can have both positive and negative result if any risks are being disregard.
Amacher, R., Pate, J., (2012). Principles of Macroeconomics. San Diego, California: Bridgepoint Education, Inc.
Keynes and The Classical Economists: The Early Debate on Policy Activism (n.d.) Retrieved from <http://wps.aw.com/wps/media/objects/11/11640/rohlf_keynes_and_classical.pdf>
Chen, H., Clouse, J., Ihrig, J. & Klee, E. (2014) The Federal Reserve’s Tools for Policy Normalization in a Preferred Habitat Model of Financial Markets. 1-37. Retrieved from <http://www.federalreserve.gov/econresdata/feds/2014/files/201483pap.pdf>
Maitah, M. (n.d.) The Fiscal Policy and The Monetary Policy. Retrieved from <http://www.maitah.com/IT/Fiscal%20and%20Monetary%20Policy.pdf>
Alesina, A. & Ardagna, S. (2009) Large changes in fiscal policy: taxes versus spending. Retrieved from http://scholar.harvard.edu/alesina/files/largechangesinfiscalpolicy_october_2009.pdf
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