Various policies have different effects on the total demand of the economy. These effects may be direct or indirect. Average partial effects face challenging problems when certain intervention measures are introduced to boost them. Explanatory policies relating to price controls, reserve requirements, taxations, interest rates, and open markets have effects on employments, commodity prices, output, and interest rates.
When policies are used to boost APE, some inconsistencies are reported by industry players. Even though most of the intended effects are realized, at least one is not achieved. When interest rates drop, investments in all sectors improve. If federal reserves expand bank reserves, lending interest rates relatively drop. As a result, APE will raise money which is not enough to restore its amount if it was initially less than GDP and ASF.
Since the required restoration of APE fails as a result of a drop in interest rates, inconsistencies of the policy in question would be visible. If a tax cut is used to counter the problem, beneficiaries use it to pay debts. Therefore, the intended purpose is not achieved.
Liquidity traps present another serious problem associated with the use of Policy intervention. Severe depressions often occur which is characterized by poor sales and profits, few new investments, and falling interest rates. When there is an economic improvement, interest rates rise. Previous lenders would start recording losses. As a result, ASF may reduce significantly. Federal reserves may not increase the ASF by any policy intervention. This is an impairment on Federal reserves to increase ASF and it can only be used during the extreme depression.
Crowding in an economy occurs if the expansionary policy is used to increase total demand without considering the rise in ASF which in turn increases interest rates. If the government has a budget deficit, it borrows from credit markets pushing interest rates up. Investments will be reduced significantly. Even if ASF does not rise during the process, the increased interest rates will push APE down to an equal constant level of ASF. The expansionary fiscal policy may fail to raise APE.
Ricardian Equivalences occur if expansionary fiscal policy forces the government to finance deficits through treasury bonds. To pay for the treasury bonds, the government must increase taxes. To pay for the increased taxes and save at the same time, taxpayers must cut down their spending hence failure to increase APE. As a result, taxpayers will be certain of an impending tax increase hence fiscal policy will not work.
To fight inflation, various policies are used in an economic system. If both ASF and APE are up, the restrictive policy may be used to reduce them to a level of GDP thereby hindering the possible macroeconomic process. This action maintains prices and reduces employment. When there is a drop in GDP, wages and commodity price controls are the most appropriate intervention. If ASF falls, monetary policy should be eased to push it up hence avoiding economic recession. To return prices down, the cost of doing business must be reduced. This method is not entirely effective in controlling inflation.
Tax-Based Incomes Policy
Tax-Based Incomes Policy is a more effective method of controlling prices. Wages to employees and commodity prices are controlled and sometimes pay rise is banned. The intention is to have an average wage and commodity price in the market. The government would set a target for wages and prices, an employer who gives an employee wage increase and an employee who accepts will suffer a tax penalty. If the opposite occurs, they are both given tax credits and relief.
Business Cycle in an economy is caused by several reasons. Cyclical fluctuation is caused by external shocks to the economy which affect prices. The macroeconomic coordination process may be used to adjust the fluctuations. Business cycles cause another cycle generator which keeps consumers with the expectation of bad economic times. People tend to adjust their expenditures hence the expansion is ended.
The government responds to high unemployment levels by boosting ASF, prices, and interest rates which may arise for a while resulting in inflation. Public outcry may force the Federal Reserve to switch to a tight monetary policy. Since the action depresses prices, employment, and boosts interest rates, the situation may require intervention. The cycle continues for a long time reinforcing other cyclical fluctuations. Various laws have been formulated to counterbalance such cycles including the Employment act 1946.
Interest Rate Policy
It is hard to boost both, interest rates and employment using an expansion policy. Fiscal policy can be used instead. In the United States, Fiscal policy is controlled by Congress while monetary policy is controlled by Federal Reserves. The macroeconomic Coordination process can influence interest rates in any way. Monetary policies can affect interest rates too, together with macroeconomic coordination processes in opposing directions. To achieve both, monetary and fiscal policies must be used.
Collected data is used by professionals to recommend various interventions to economic instabilities. To measure GDP, the Department of Commerce collects information in phases and estimates are released early. The final GDP normally varies, with initial estimates suggesting that the data collected is unreliable. They also measure various components of APE making sure they correspond with GDP. Data does collect do not show the amount of United States currencies circulating in the world.
Policymakers need to discover problems in an economic system associated with employment, interest rates, prices, and output, early enough to counter them. This eventually reduces the coordination process, and appropriate policies are developed. During the transfer of bonds, open market intervention normally lags because it starts from Manhattan only. Congress and Federal Reserves should strike a balance between them and develop policies that can counter data problems, policy lag, and random macroeconomic shocks.
Just like families and artisans, nations cannot produce products that cost more at home than what another country can use to produce them. Specialization has enabled several countries to produce goods which they are good at, and then export to other countries. When developing an expansive export-oriented industry, several problems are faced including pollution, social friction, competition, and congestion. Some countries, including the United States, protect local entrepreneurs against unfair competition from foreigners while maintaining the expansion of international trade. Tariffs and quotas are used to achieve this. High taxes are imposed on imports to give local products a competitive advantage. Quota controls the amount of product to be imported.
Absolute and Comparative Advantage
Total specialization is rarely achieved. Although countries specialize in the production of some products, still they import the same products from other countries and export theirs to foreign customers. The U.S. is a good example because it cannot entirely produce a product for export or import it in totality.
Two countries with two similar products illustrate an absolute advantage. Take two countries ‘A’ and ‘B’ producing two products, X and Y each. If both countries can produce both products with different capacities, their absolute advantages can be calculated. To do this, a line graph is plotted for each country. A graph of product Y against product X is plotted. The line plotted is called the production possibilities frontier.
A country can attain productive efficiency on the line but can maximize efficiency if the optimum number is calculated for the two products. If one country is more efficient in producing one product than the other, it will rather use all its capacity to work on that product and maximize exports and income. A country will then forego one product for the other. However, if two countries producing similar products have the same opportunity cost for both products, they would not benefit from one another.
Therefore, opportunity costs must differ for both products to engage in constructive business. Considering the value of currencies of both countries, the cost of production of the two products can be compared before trading. A compromise is reached if each country has an absolute advantage over the other in one product. As a result, both countries forfeit the production of the other product.
Specialising allows people to produce more of what they are best in. However, this brings in the interdependence between individuals and countries. When two countries sign a trade agreement, they specialize and abandon one product each. The country tasked with producing a product must produce a quantity equivalent to other country’s demand. The two countries will have a sufficient supply of both products but lack a balanced trade.
In comparative advantage, two countries engaged in the trade of two products, but one country has an absolute advantage for both. To strike a balance, percentage advantages are compared. A country should produce one product which has higher advantages over the other. The country with disadvantages should pursue products with fewer disadvantages to reduce the margin and enhance profit. Countries that specialize in products lower their opportunity cost. Currencies exchange rates should play vital roles in the cost of the product and final decision on the one to specialize in. Trade will be enjoyed by both countries if the exchange rate is harmonized and both products are supplied sufficiently.
What We Import
Comparing products from two countries when one country can produce or import one product will depend on the cost of importing and the cost of production. Exchange rates of currencies, cost of production, and production capacity are used to calculate and determine what to import. Cheap product from a foreign country tends to displace the same expensive ones produced locally. When supply increases, prices must come down to increase demand for the product.
What We Export
When a product is produced locally in excess, a foreign market is needed to sell the surplus. The price must reduce in foreign countries significantly. Exchange rates of both countries compete because of the product in the market. If the rate favors consumers in an importing country, demand for the product increases. On the other hand, if the rates are not in favor of the consumer, the importing country would reduce its demand. This creates room for the country to export another product to the trading partner. If exchange rates fluctuate, few traders enter the export and import market.
Comparative and absolute advantages have various benefits to countries that specialize in products. In many countries, income does not go directly to people. When a new product is introduced by a foreign supplier and not restricted, it will be available at affordable prices. The product increases in the domestic supply hence adjusting various market elements. More suppliers of a product increase competition, enhancing creativity, lowering prices, and improving quality.
Consumers benefit while GDP suffers due to reduced local expenditure and unemployment. The use of consumer and producer surplus helps to understand this arrangement. Consumer surplus represents net benefit accrued to the consumers, while producer surplus is the benefit accrued to suppliers of products.
While entering a new external market, a supplier exposes its products to demand based on price. A new product adds to a country’s products and adjusts equilibrium while demand increases. With free trade, the price of the commodity increases and availability reduces while consumers are harmed by the exportation of the product. Local producers of the same products benefit from the increased prices and may maximize their profits. Output and employment record upward trends. The benefits and harm caused by the products are compared using consumer and supplier surplus curves to understand. Harm may be countered using quotas and tariffs.
If imposed on importers, local producers produce and sell their products too. This results in a significant loss to consumers’ surplus although they may not be aware. Governments listen to producers rather than consumers in such a situation. On the other hand, export restrictions benefit consumers and harm domestic producers. Major benefits are evenly spread across several consumers, while positive impacts on producers will be less. Because of the small benefits, exporters would complain to the government to lift restrictions
Tariffs are taxes that make imported products more expensive compared to local ones and generate revenue for the government. Developed countries use them to protect jobs, respond to other countries, maintain product viability, or protect infant industries. Sometimes tariffs invite retaliation. This denies the country’s employment, sales, and output. At times, suppliers depart due to either war or other reasons, and a country may not have a local producer.
A country should prevent such a situation from occurring by overcoming competitive advantage when compared to foreign competitors. When a government thinks a product is vital, it can empower a local company and impose tariffs on imports. The tariffs are absorbed by the foreign exporter and passed on to consumers. High tariffs sometimes squeeze out importation.
A quota, on the other hand, works almost in the same way, but it limits the amount of product to be imported. This method does not generate any revenue for the government but benefits are ripped by third parties. Tariffs and quotas are important in controlling and protecting domestic producers from foreign competitors. However, they hurt consumers, foreign exporters, and cause retaliation.
This can be avoided by the use of incentives and subsidies to give domestic producers an advantage over importers. Using subsidies does not elicit retaliation. Countries restrict export by limiting the number of the license issued to exporters for a specific product.
The Foreign Exchange Markets
Every country has a currency used within its boundaries. Some countries have a common currency. When a transaction is made in a foreign country, the amount paid in foreign currency must be equivalent to the value of the goods being sold in local currency. A buyer can pay in a foreign or local currency, but the value must remain the same. The value of a currency varies with time because of various factors.
A decrease and increase in the value of a currency may affect negatively or positively the foreign exchange market. Goods may eventually be cheaper or more expensive, depending on the exchange rate. Holders of a particular currency may opt to exchange currency first before purchasing. Taking the dollar and Japanese yen as an example, the value of a dollar will decrease if its demand in the market is lower than normal. If the demand for the dollar is high, and the value goes up, the holder of the dollar is wealthier than the holder of the Japanese yen.
Balance of Payments
The balance of payments is a record of cross-border transactions made by a country’s institution. In the U.S. there are two parts
- Current account- records of imports and exports international income payments.
- Financial account- records the foreign acquisition of stocks, assets bonds, and acquisition of comparable foreign real and financial assets.
In every system, the value of a currency against a foreign one coming into a country must be equal to payments going out of that country. A good example is a euro in the European market and the American dollar. Adjustments in their value keep their payments balanced. If the total value of income and payments has a sum of zero, the country’s account surplus and the simultaneous financial deficit is equal to it.
The value of these currencies can affect trading at international levels. It has been well managed by many countries in the past years to limit fluctuations. The pegged exchange rate system is a famous currency exchange that was used to stabilize currency from 1880 to 1914. Another exchange system was used during war 1918-1939 and after world war II which was called the international gold exchange standard.
International gold standard
The international gold standard was started around 1880 with conditions requiring nations to define their monetary units in terms of gold. It also allowed the movement of gold in and out of countries. Currencies were used to buy gold without limit. This ensured that the monetary value was equivalent to gold in a country’s treasury. Being the largest trading nation United Kingdom traded its 113 grains of gold as Pound Starling (£).
The U.S. dollar was 23.22 grains of gold. With these facts in place, a par of exchange was developed. The standard provided them with either foreign exchange using currencies or governments using gold. When currencies became expensive, dealers would sell gold to other dealers to be sold to their government for the currencies. These exchange rates controlled inflation perfectly well. If interest rates were high in the U.S. and down in the U.K., dollars could have been invested in the United Kingdom. Much money could have been attracted to the U.S. from the U.K. to earn interests. American commodities looked more attractive when prices went down in the U.S. compared to the U.K.
American people would buy a few goods imported from the U.K. because of depressed income. On the other hand, Britons retaliated by buying more goods and services. A rule was set to be followed by countries running a balance-of-payments deficit. These countries were required to cut their domestic money supply because of gold outflow which would make the economy tend to severe recession. If gold inflow increased, a country was required to increase its domestic money supply pushing the economy into inflationary expansion. The United States created the federal reserves system and trained its staff on the rules in 1913.
However, the international gold standard ended in 1914 and the Great Depression started in Europe and was followed by the United States in 1929. Federal reserves used the set rules in their internal affairs and later reversed the policy. The international gold standard helped stabilize exchange rates but many countries could not tolerate its inhuman nature.
The International Gold Exchange Standard
Before the end of the Second World War, several nations agreed to come up with a new system as opposed to the international gold standard which could not support expected economic growth. The available gold could not support the fast-growing economy expected after World War Two. The standard was also harsh on deficit countries and this made growing nations to develop a system for controlling exchange with minimum side effects.
The Bretton Woods System
Bretton Woods System proposed that each government take active roles in foreign exchange markets to prevent exchange rates from varying by more than one percent from its pegged level. If exchange rates of two currencies exceeded one percent from the pegged level, the governments responsible would be obligated to bind an agreement to step in and eliminate excess currency. Deficit countries formed the International Monetary Fund with each member being allocated a quota. IMF had a quarter of resources in its coffers as gold and the remaining three quarter as member countries’ currency which would be used to stabilize countries with the deficit.
Setting Exchange Rates
Using a freely-fluctuating exchange rate system, the rate between two currencies was set using the projected average in ten years. This would vary over a very long period and would be set after a five to ten-year period. Required adjustments between the two countries were advised by the IMF.
How the System Performed
The system was used after the Second World War since there was a need to rebuild economies. The United States took the lead because its economy was undamaged. With a small number of dollars in the market, other currencies lost their value to it notably the Japanese yen, West German Mark, and Pound Starling. Dollar shortage ended four years after the end of the Second World War in 1950. This was boosted by Americans’ habit of buying foreign products which were cheaper than domestic ones. Dollar flowed into the European foreign exchange market when an idea of a common market was introduced.
Americans invested in Europe to benefit from the common market. This was boosted by the development of military facilities all over the world and the provided aid to struggling countries. Since Americans believed that its currency was protected by Bretton Woods System, it insisted that West Germany and Japan should increase the value of their currencies. It also encouraged its citizens to buy domestic products.
Both Japan and West Germany were ignored because of their economic reasons. United States balance-of-payment went up with traders in Japan and Wes Germany accumulating unwanted dollars. It was expected that the United States would devalue its currency but no action was taken until 1971. The decision by President Nixon to increase the value of the dollar on gold forced West Germans and Japanese to back away from Bretton Woods System. The dollar sank in 1973.
Pegged versus Flexible Exchange Rates
The value of the currency was not allowed to drop more than one percent of a pegged value before 1973 but now currencies are allowed to fluctuate freely. This has made APE responsive to changes in interest rates and GDP which results in increased imports. Depreciation of dollar against foreign currency would have boosted APE which would have not been possible under Bretton Woods System. As a result of these conditions, Federal Reserves has embarked on the enhancement of domestic policy instead of relying on intervention from monetary authority. Tightening or loosening of monetary policy would affect international financial capitals in the country.
Fed must sell enough dollars to foreign markets to avoid appreciation of dollar internationally which would later be used by foreigners to buy products in the United States hence neutralize the Fed’s original monetary contradiction. In other words, flexible exchange rates impair domestic fiscal policy effort slightly and enhance domestic monetary policy.