Wednesday, February 15, 2012

Research Proposal on Monetary Policy

Research Proposal on Monetary Policy

Classical economic theory (Adam Smith, etc.) assumed that a "free-market" economy is a "self-regulating" system that continually tends towards full-employment equilibrium, with optimum economic benefits for everyone. Therefore, the best government economic policy is to "get out of the way" and give maximum freedom to individual enterprise. The term 'Classical' refers to work done by a group of economists in the 18th and 19th centuries. Much of this work was developing theories about the way markets and market economies work. Much of this work has subsequently been updated by modern economists and they are generally termed neo-classical economists, the word neo meaning 'new'. Classical economic believed that the government should not intervene to try to correct this as it would only make things worse and so the only way to encourage growth was to allow free trade and free markets.

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A key element of the "Keynesian revolution" was its demonstration that these basic assumptions are false, both in theory and practice, and its assertion that, the most appropriate government macro-economic policy is to view the whole economy as if it were a single huge business enterprise which needs to be managed as one. During the great depression John Maynard Keynes asked, "If supply creates its own demand, why are we having a worldwide depression?" In view of this question he advocated massive government intervention to bring an end to the Great Depression.

Fiscal Policy is when a national government makes decisions on taxation and spending with a view to influencing the level of production and employment. (Fiscal Policy and the Simple Keynesian Model, 2003)To many people, the Keynesian Revolution is often associated with the rationalization of active government macroeconomic policy. Indeed, one of the major appeals of Keynes's General Theory was precisely that it seemed to lend theoretical guidance to policy-makers in an era when the Great Depression still had its grip on the industrialized world and Neoclassical economists offered no tools, if not quite the wrong tools, to address it.

Even though fiscal policy is a classic theme in macroeconomics, there is no consensus about the size or even the sign of its effects on private sector behavior. Public comprises like public expending, taxation and any other Government income or assistance to the private sector (such as tax brakes) can be used to influence the level of demand in the economy, usually with the goals of getting unemployment as low as possible without triggering excessive inflation. If we use the same argument from the 1930s, we can say that the level of total output or production in the economy is due to the aggregate demand, this being the total spending of consumers, businesses, government and foreigners. In today's economy and due to all the events that had transpired in the last two years the economy has fallen into a recession, and this can be caused directly because of the lack of spending, which is due to the lack of aggregate demand, we can look at it as a chain reaction; the economy start to slow down, the tragic events of 9/11, and combined with the consumers apprehension of the market, all these issues will lead to shortage of government spending, unemployment, etc.

Using Keynesian theory, this can be solved by increasing government spending or by lowering taxes. This will raise aggregate demand and reducing unemployment, thus encouraging economic growth. GEC and organization that deals with the US Military could be an example of how Keynesian theory works. Since this organization is a sub-contractor for organizations like Northrop, Boeing, Lockheed, L3, Raytheon, and directly with the US Military, it depends on the fiscal budget. In order for the company to obtain contracts, these contractors need to get their budget from the government, thus depending on Monetary Policy. One of the things we can look at is solving unemployment by using Monetary Policy: increase government spending should be the answer. By expanding the money supply extra spending would occur, encouraging the firms to produce more, thus employing more personnel. The problem with this approach is that demand and supply functions would be affected. Problems with demand could be because of shortage of money while supply could be affected because of problems with firmed wages. This is a monetary policy which looks at controlling the money supply by deciding on interest rates and rate of inflation in order to control variables like unemployment. We could try to solve this problem by combining both, Keynesian policy and Monetary Policy, and hence bringing together the goods and money markets in important. If monetary policy grows thus simulating interest rates, the GDP should grow. The decrease in interest leads to en increase in spending (investment). This input into the economy will result on an increase on GDP and the growing economy.

My assessment of this issue is that if rise on money supply means that supply is greater than demand, the firm would be in good shape because of the extra cash to spend. On the other hand, Keynesian view of economy is that the economy falls into a trap of liquidity. When the money supply is increased, the net result here is that the interest rate or GDP change. Using Keynesian policy as a solution for this liquidity trap, we would have to use fiscal policy. The result would not change interest rates, and will increase national income (government spending would increase). As the input is greater than withdraws, the GDP would grow, and as income grows the monetary equilibrium is not lost. So, for the firm it would be better to use Fiscal Policy because it would not be affected.

I would conclude that there are differences on Fiscal Policy and Monetary Policy, and recognizes the importance of both and a correct balance of the two in order for the economy to be under control.

Supply and Demand policies being used at the same time to control the economy will have affects on both the goods and money markets, so the monitoring of any policy used is essential. In this paper I tried to argue that whatever policy is used, various problems will undermine the effectiveness of the policy, and the success of fiscal policy will depend largely on the accuracy of forecasts. I gather that no one policy is good and can be used by itself, it needs to be combined with another policy to better stabilize the market.
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