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Business Cycles, Fiscal Policies and Monetary Policies.

Sunday, September 26, 2010

I have always maintained that having some knowledge of Economics is useful in the modern world.  A reader, Paul, happens to be a student of the subject at a higher level.  He has kindly emailed me some essays which he has given me permission to publish.  I hope you find them as interesting as I have.

Business Cycles, Fiscal Policies and Monetary Policies

Business cycle refers to economic expansions and recessions. Developed economies normally have a 3-5% GDP growth annually. USA's potential GDP growth is about 2.5%. A recession happens when an economy has 2 consecutive quarters of negative GDP growth. Depression is a recession on a larger scale. It refers to a period when the GDP output falls by more than 25% and when there is high unemployment rate of about 20%. Depressions are longer in duration, often lasting more than 4 quarters.

Economic recessions could be the result of internal shocks and external shocks. In a recession, there is a lack of effective demand for goods and services. Some economists view recession as a natural occurrence as the economy goes through structural changes, as moving from sun-set industries to sun-rise industries. A recession could also be caused by structural failures such as the banking system. In short, the economy has to shed its excesses to be healthy again.

In the years prior to the recent financial crisis, Robert Lucas and Ben Bernanke declared that the central economic problem had been solved, business cycles were tamed and severe recessions were things of the past. We all know what happened in 2008.

After the Great Depression in 1930s, governments worldwide actively tried to tame the business cycles. USA went through a strong period of recovery powered by the industrial sector. The recessions were short and mild, while the recoveries were strong and sustained. This led to questions if the business cycle was obsolete? The next depression in the US was in 1970s, caused by external shocks such as the high oil prices. In the 1990s, the world again went through another period of small recessions and strong economic growth, which led to the comments made by Robert Lucas and Ben Bernanke. Is complacency one of the causes of the recent financial crisis?

Fiscal and monetary policies are employed by governments trying to tame the business cycle. Fiscal policies refer to the G component, which is the government. In times of economic expansion, governments would raise taxes, and cut their spending to prevent overheating of the economy. These are called contractionary fiscal policies which could lead to a budget surplus. In recessions, governments have to lower taxes and increase spending to stimulate demand in the economy. These are called expansionary fiscal policies which could lead to a budget deficit. For example, lowering taxes for both consumers and producers would increase their real income, and increase their spending respectively, all else being equal. This would result in a higher C and I component which increase the national income.

Monetary policies involved using the money supply to influence the interest rates. When money supply increases, interest rates will fall. When interest rates fall, cost of borrowing for both consumers and producers will fall. For example, this could lower mortgage interest payment for consumers and make it cheaper for producers to borrow money from the banks. This would again boost demand through C and I. Lower interest rates would also weaken the currency of the country, which would be positive for the country's trade balance, all else being equal.

Central Banks would normally be responsible for monetary policies in a country and they are supposed to be independent from the government with the main objective of achieving price stability, with an inflation target of 1-3%. In the recent crisis, Central Banks around the work also resorted to different methods to increase the money supply, such as quantitative easing and the use of reserve ratios for commercial banks.

As mentioned earlier, adopting expansionary fiscal policies could lead to deficits. Budget deficits could be funded by surpluses from previous budgets or the issuance of bonds to borrow from the market. As mentioned in earlier blog posts, most governments resorted to the issuance of bonds to finance budget deficits in the recent crisis. These bonds can be bought by domestic or foreign investors. Hence, we have the figures of debt to GDP ratio. When foreign investors are involved, it would cause movements in the exchange rates, due to changes in demand and supply of the home currency. This is one of the reason why Japan is upset when the Chinese government bought much more Japanese government bonds( JGBs) recently.

These policies are called demand side management policies, as they are used to stimulate demand in the economy. If fiscal spending is carried out to improve supply in the economy, for examples, through education and infrastructure spending, which would increase the future productivity of the country, then, these would be called supply side policies. The Singapore government has been constantly engaging in supply side policies through retraining programs for workers, investments in the education system, construction of new infrastructure such as metro rails, implementation of tax incentives for engaging in R&D activities etc. This would boost the country's productivity and competitiveness in the future.

The readings below focus on debt issues, and fiscal, monetary policies.

Sovereign Debt

Corporate Debt

Consumer Debt

Fiscal and Monetary Policies

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