The Way To Stimulate Growth Economics Essay

The leading views on these policies and its usage are Keynes and Friedman, Keynes who was structuralist believed the way to stimulate growth was through the use of expansionary fiscal policy, this meant increasing government expenditure more than tax revenue and to finance this through borrowing. Keynesian economics was popular post World War 2 as demand was very low in this time, it was believed the best way to stop this was the extensive use of fiscal policies, Then around the 1980s policies moved away from fiscal to monetary, until 2008 when VAT was cut from 17.5% to 15% which was used to try and increase consumer spending by reducing prices, “The Centre for Economics and Business Research (CEBR) estimates that the 13-month tax cut helped boost consumer spending by £6.8bn”(http://news.bbc.co.uk/1/hi/8435887.stm), This research highlights how the reduction in taxation did boost spending and economic growth in our economy. On the other hand Friedman a neoclassical economist believed in less government intervention, that demand side policies could not help our economy “Friedman’s conclusion about stabilization policy is precisely the opposite: … Governments cannot stabilize the economy – fiscal and monetary policies are ineffective in tackling unemployment and stimulating output in the long run”(Wetherly and Otter,2008,Pg196). Wetherly and Otter explained how Friedman believed quite the opposite to Keynes, that demand side policies should not be used and that they would only damage our economy in the long run. These views can help to explain how policies can be effective and ineffective in promoting economic growth.

One way in which demand side policies can stimulate growth is fiscal policy through the use of government spending, this is done in order to try and increase expenditure in the economy, Keynes believed in expansionary fiscal policy, this was spending more than was earned through tax revenue and to be financed by borrowing. This can stimulate growth because if the government increases spending on education, this may create jobs, this will then increase incomes for people, they will then increase their spending in the economy and therefore create more jobs causing a snowball effect, this meant a little increase in government spending increases expenditure and demand a lot more making the money more effective, this is known as the multiplier, developed by Keynes. Hoover dam is a great example, American governments spent 165m to construct Hoover Dam this created 10,000+ jobs, this was a major success for the government as it helped boost spending in the economy and created billions of dollars in growth(Sourced: http://www.youtube.com/watch?v=f7WDzL1hjqQ).

Another way government can stimulate growth is by subsidising products to reduce price for consumers, this means people will buy more and demand will increase. This was done by the UK government with the car scrappage scheme, this allowed people to trade in their old cars and be given a £1000 off on your new car courtesy of the government, this helped to revive the car industry in the economy and increase spending and demand in the economy.” A total of 168,942 new cars were registered in October, up 31.6% from a year ago … It marks the fourth month that car sales have been boosted by the scrappage scheme”(http://www.guardian.co.uk/business/2009/nov/05/uk-car-sales-30-percent-up-october) This test done by the Society of Motor Manufacturers showed that the car scrappage scheme had in fact increased demand in the economy for new cars therefore stimulating economic growth.

Another fiscal policy is taxation, “If fiscal policy is used as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the marginal propensity to consume is, of course, all the greater “(Keynes,1997, pg95), this explains that taxation used in order to increase peoples incomes or reduce price of products will mean people can afford more and will then demand more, and as “The amount of aggregate consumption mainly depends on the amount of aggregate income”(Keynes,1997 pg96) then aggregate income is key to influencing economic growth. This policy was used by the UK government when VAT was cut for 13 months in order to try and stimulate economic growth.

Another demand side policy used is monetary, One way this can influence economic growth is through Interest rates, “The rate of interest governs the terms on which funds are being currently supplied”(Keynes,1997,Pg16)” this means lower interest rates increase incentive to borrow and reduces incentive to save and as “Expenditure on consumption is cet. par. Negatively sensitive to changes in the rate of interest”(Keynes,1997,Pg93) this shows that lower interest rates will increase borrowing for investments and consumption in the economy, and therefore will increase economic growth.

Another way monetary can be used is quantitive easing, this is when the government electronically creates extra money to buy assets from investors, investors will not want to keep this money as it gains low returns, they will then invest it in other assets, this then increases spending and economic growth., “As of September 2012, the Bank of England had committed a total of £375bn to QE, while on 14 September the Fed said it would spend a further $40bn (£35bn) per month.”(http://www.bbc.co.uk/news/business-15198789). This shows that monetary policy has been used in many countries as an attempt to bring them out of the recession by stimulating spending to increase economic growth, This has had some success in the UK economy as suggested by Charlie Bean “Economists at the Bank of England have used a variety of empirical methods to estimate the effect of the first tranche of £200bn of asset purchases in 2009-10.  The results suggested that those asset purchases boosted GDP by about 1.5% to 2%.”(Charlie Beans speech 21/02/12 :http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/mpcviews.aspx#a).

However these demand side policies are not always effective at stimulating economic growth, This can be shown through the Philips curve, at point A expected inflation is 0% and unemployment UN , So now by reducing interest rates to boost economic growth and reduce unemployment to U* will cause movement from A to B, firms expand their output and employment increasing inflation to 2%, But firms expected 0% and based decisions around this, this causes a shift to SRPC2 and economy moves to point C. This shows that now unemployment is back at UN while inflation has risen to 2%, if this continually happened we would eventually move up to point E.

SRPC3, Expected inflation = 4%

Long-Run Philips curve

SRPC2, Expected inflation = 2%

SRPC1, Expected inflation = 0%

A

C

E

D

Unemployment Rate

Inflation Rate

2%

4%

UN

U*

B

So “If governments persist in indulging in over expansionary fiscal and monetary policy it will simply drive up inflation rate … effectively it will be choosing more inflation without any advantage in reduced unemployment”(Wetherly and Otter,2008,Pg194), this explains that after a certain point fiscal and monetary policies to reduce unemployment in an attempt to boost economic growth will become ineffective and just purely increase inflation making them inefficient.

Monetary policy can be ineffective as well, For example Quantitive easing this is because sometimes the extra money created is not always used for the purpose it has been created for, This can be seen in the current recession, the Bank of England created extra money to be put into the banks, this was done to try stimulate lending in the economy, but instead banks were saving this in order to strengthen the financial position of the bank, “these efforts had diluted the effect of quantitative easing, by increasing the chance that the extra cash the Bank had injected into the system would sit idle on bank balance sheets instead of being re-lent.” (http://www.bbc.co.uk/news/business-18439419). This article suggests the extra money created had been ineffective in stimulating growth as most was being kept by banks rather than being lent and as “control of the money supply is the key to economic stability”(M.Friedman,W.Heller,Pg18) Friedman clearly highlights this must be rectified to promote economic growth.

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Fiscal policies can be problematic as well; this can be seen today with the government’s budget position “In 2009, the UK national debt hit a record of £799,000million … 56.6 per cent of gross domestic product … highest since records began”(http://www.bbc.co.uk/news/business-18967294) this article emphasises how Britain is now at its worst budget deficit ever and although Keynesian economists may translate this into increased government expenditure to boost economic growth it will also heavily impact the amount governments can spend in the future, and as Jonathan Portes says “Debt matters because it has to be paid,” so is this agreeing with freedman’s view of tight control of your money because this impact the use of fiscal policy in the future, because if we have to pay our debts back we will not be able to use government expenditure in the future to influence demand thus rendering ineffective in the long run.

Fiscal policy can be ineffective due to time lags, as “government may decide that it wants to invest in the economy and put together a programme of greater spending on health care. This has to go into the budget, be voted on, and for this to feed through into more jobs and greater spending by the construction firms and employees may take even longer”( Gillespie,2010,pg358) As Gillespie explains to increase government spending there are many processes that policies must go through and by the time the policy actually comes into affect the economy may have changed so much that now it is not needed. Time lags can be a major problem in making polices ineffective as it is hard to foresee what problems may occur in the future so that we have the right policies in place to create economic growth.

Demand side policies will only be effective up to a certain point on the AD curve as when we are at full capacity demand cannot increase anymore and this will cause increased inflation, so when economies are at a certain point, these policies will become ineffective and will only increase inflation, damaging economic growth. One way we can solve this is by using supply-side policies these are designed to increase the productive potential of economies so demand can grow further, Some ways this can be done is by Privatisation, this will increase competition, increase productivity as firms seek to most cost savings to increase their competitive advantage, This was seen with the privatisation of British Gas and British Telecom’s. One way governments have attempted to do this recently is by increasing the school leaving age up to 18, this is designed to increase students skills in order to improve their chance of being employed, this will then hopefully translate into more productivity thus enable to productive capacity of the economy to increase so that demand can then increase without inflation helping to boost economic growth.

However supply side is not actually effective in stimulating economic growth it does not affect our consumption habits or increase the incentive to spend so really supply side is ineffective when it comes to stimulating growth. But these policies are essential in order to enable demand to grow as when we are at near full capacity, without these policies demand would only be able to reach a certain point before inflation hits and demand reduces again, so even though these policies do not directly affect growth they allow growth to continue when at full capacity, this makes these policies as important as demand side policies and should be taken into account heavily.

Whether or not demand side policies are effective at stimulating demand will depend on what stage you are at in your economy, when unemployment levels are high and demand is low, demand side policies are essential to creating growth, But the government’s budget must be taken into account as spending now may impact its sustainability in the future which will impact how much you can influence demand in the future. If economies are at full capacity then demand side policies will be ineffective, this will mean supply side will become more in important as demand will only grow when you can handle it. So in conclusion there is no one policy that will be most effective to stimulating growth, to give a clearer picture you must take into account factors such as governments budget and position of the economy because if not you may end up using the wrong policies at the wrong time making it very unbeneficial to the economy and its growth.