Discuss below in a 250 words each:
Question 1
Read the following article and answer the questions at the end.
"But I don't feel stimulated" by John Slayton
PRESIDENT Obama recently signed an $800 billion Stimulus Plan and submitted his 2010 Federal Budget to Congress, resulting in a $1.75 trillion+ increase to the federal deficit. The President hopes to halve the budget deficit within four years, partially through $989 billion in new taxes. Americans making over $250,000 annually will fund up to $700 billion in additional tax revenue over a 10-year period:
• Expiration of Bush tax cuts - $338 billion
• Elimination of itemized deductions - $179 billion
• Raising capital gains tax - $179 billion
The recent heated debate over how to deal with the deepest recession since 1930 has focused on the differences between two historical economic approaches - Supply-Side vs. Demand-Side Economics. It is tempting to dispatch such debates as academic, partisan dribble, but the outcome is going to have a very real impact on our wallets and lifestyles for years to come.
Supply-Side Economics, as popularized by Ronald Reagan and espoused by economists Milton Friedman and Friedrich Hayek, argues that tax cuts to high tax bracket individuals and corporations enable investments in production in the private economy, thereby increasing the supply of goods and employment. The increase in supply drives down prices, increases demand and results in increased economic activity, which results in added tax receipts. As evidenced by the 2001 Bush tax cuts, decreasing tax rates actually results in higher tax receipts. On the other hand, the President and the Congressional majority have firmly embraced Demand-Side Economics, as sponsored by John Maynard Keynes during the Great Depression. Keynes argued that getting an economy out of a rut requires stimulating demand through government spending, tax cuts and rebates to the middle class, so that they demand and spend more. General employment is closely correlated with aggregate demand for consumer goods, so during recessions the government should borrow money and spend it in order to drive the economy. The "Keynesian Multiplier Effect" posits that real GDP rises by more than the actual government spending, because idle resources - unemployed labor and capital - are put to work to produce added goods and services. The Obama budget assumes a multiplier of around 1.5, meaning that every $1.00 the government spends on "shovel-ready" projects and lower/middle class tax credits results in $1.50 benefit to GDP and every 1 percent improvement to the GDP results in 1 million jobs.
During the Great Depression, Keynes argued that with consumer and business spending so weak, governments had to boost demand directly. FDR's public works job programs and the increased government spending during and after World War II eventually ended the Great Depression. Keynesian policies were popular until the late 1970s, when government spending was blamed for spurring worldwide inflation. Supply-siders argued government deficits drive up interest rates and hinder more efficient investments in the private sector. With the rise of Ronald Reagan and Britain's Margaret Thatcher, shrinking government became the predominate goal. Monetary policy began to play a bigger role than fiscal policy, as central bankers drove up interest rates in order to fight inflation. The era from the early 1980s to the recent crisis became known as "the Great Moderation," with less volatility in economic activity and inflation. Unfortunately, monetary policy has not and will not cure the current economic crisis.
The Obama administration and the Democratic Congressional majority are trying to cure our economic woes with increased discretionary spending. Unlike the 1930s, however, discretionary spending on roads or bridges has been marginalized by huge entitlement spending (Medicare, Medicaid and Social Security) and is no longer an effective fiscal tool. Borrowing or printing money to pay for the Stimulus today will result in higher taxes or higher inflation (or both) in the future. Arguably, we should focus on incentives (reduced marginal income tax rates) for people and businesses to invest, produce and work, rather than programs that throw money at people or massive public-works programs that do not pass muster. Stimulus spending that takes resources away from those who are productive and redistributes them to politically favored interests assumes that government knows better how to spend and invest than do private individuals and industry. Income redistribution through a Trojan horse of Democratic policies, cloaked as Stimulus, should not be confused with sound economic theory. In reality, no one spends someone else's money better than they spend their own. The Stimulus Package is all about politics and power, not sound economic theory. To be informed is to be empowered.
Source: John Slayton, ‘But I don't feel stimulated', Times-News, Burlington, NC, 4 April 2009
Questions
1. Use a Keynesian 45-degree diagram to show the effect of an increase in government spending.
2. How could a reduction in tax rates increase government's tax receipts?
Question 2
Read the following article and answer the questions at the end.
"Basel gives central banks power they really need" by Ian Verrender
RESERVE bank governor Glenn Stevens has raised the spectre of yet another interest rate rise.
That shouldn't come as any great surprise. With mineral exports booming and rural commodities acting in sync for the first time in living memory, our economy is facing a massive inflow of cash from overseas.
That's one of the reasons the Australian dollar is so strong. That and the fact that leaders in the developed world - other than our own
Julia Gillard - are devising more fiendish means to push their currencies lower while maintaining interest rates at just above zero in a desperate attempt to revitalise their economies.
But as Stevens delicately attempted to explain the finer points of monetary policy - and specifically the blunt axe of interest rates - to an audience in Shepparton yesterday, a quiet revolution has been proposed in the way central bankers run economies.
One of the least reported and least understood recommendations to emerge from the gathering of bankers in Basel, Switzerland, last week is a measure that will enhance central banks' power to control their economies.
For most of the past year, bankers and their well-resourced lobbyists have spread fear through the developed world, saying any regulations restricting lending will inevitably lead to lower economic growth, to the detriment of everyone.
The new regulations - insisting that banks have far greater reserves to cope with the kind of economic meltdown seen in the past couple of years - were not as bad as some had feared.
When fully implemented in 2019, banks will be forced to hold 7 per cent of their equity in reserve, to act as a buffer if a global crash puts them in peril. That is way above the current requirement to hold just 2 per cent of equity.
But an optional third measure has been adopted. This enables central banks to impose greater restrictions on lending during boom times, forcing banks to set aside up to a further 2.5 per cent of their equity. It is this measure that makes enormous sense and potentially gives regulators greater power in curbing asset price bubbles, providing them with another tool to regulate the economy.
Under this option, regulators can force banks to put more of their capital aside at the time they can most easily afford it, but at the very time most would be recklessly chasing market share by lending even more, fuelling asset price bubbles.
Until now, central banks have been primarily concerned with inflation. The thinking has been: keep inflation under control and prosperity eventually will follow. Push interest rates higher when the economy is strengthening, ease off when it cools.
That works fine when things are ticking along nicely.
Unfortunately, when the global economy was perched on the edge of the abyss in late 2008, no amount of interest rate cuts seemed to work. Even now, unemployment in the US is sitting near an uncomfortably high 10 per cent and Japan shows no sign of recovery.
As a result, central banks have come under attack for allowing the sharemarket booms and the property bubbles that have wreaked so much havoc. Why couldn't they see what was happening in US real estate? How could they not have known that Wall Street's investment banks were dropping fuel on a raging firestorm?
The answer is that the US Federal Reserve and central bankers in Europe were fully aware of what was happening but chose to let markets behave the way markets do.
They've always believed that it is not their role to interfere and that those engaging in reckless behaviour should suffer the consequences.
Not anymore. They've now learnt that catastrophic market collapses can affect not just rich investors, but the broader economy.
Hence the new tools. By restricting lending during an obvious boom, central banks may be able to moderate asset price bubbles in share, bond or property markets.
At the moment, banks tend to cut back on their lending during market downturns, when they are desperately attempting to restore their damaged balance sheets. That has the effect of deepening a recession.
The idea behind the new Basel III recommendations is that money hoarded during the boom can then be released during a recession.
Will these new measures ensure we never see a repeat of the past few years? Absolutely not. There will be another crash. Most of us won't see it coming. But every major market crash in the past three decades has been preceded by reckless lending on the part of the world's biggest banks.
The big question, though, is that if highly paid commercial bankers can get it so wrong so often, can we trust bureaucratic central bankers to keep them in line?
Source: Ian Verrender, ‘Basel gives central bank power they really need,' The Sydney Morning Herald, Business Day, 21 September, 2010,
Questions
1. Why would banks tend to lend more in booms and less in downturns?
2. What do these proposals mean for the RBA's policy of targeting inflation?