Econ 116 Problem Essay 7

8/14/2019 Econ 116 Problem Essay 7

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Nathaniel KanEcon 116a, TA: Akiko, 5pmProblem-Essay #7

Email to: [email protected]

Subject: Macroeconomic policy for the second half of the first term

The following is my personal plan for dealing with the current economic

situation, focusing specifically on increasing military related output and decreasing

unemployment to prevent a recession. Let me know how it goes.

PART 1: CURRENT STATEOFTHE ECONOMY

The economy is in a bad spot. The 2001 real GDP was estimated to be 9,214.5

billion dollars, and this year's real GDP is estimated to be 9,377.8 billion1.

Unemployment, however, has jumped a full percentage point from 4.8% to 5.8% since

the past year, and what used to be a Federal Budget Surplus of 206.8 billion in 2000 has

turned into a deficit of 168.1 billion2. Inflation has been falling, from 2.8% in 2001 to

1.2% this year3. If the inflation rate continues to fall any more, there is the risk of falling

into deflation.

With increasing unemployment comes the immediate risk of the economy falling

into a recession. Unemployment is forecasted to rise to 5.9% in 2003 before it drops in

2004 to 5.6%4, which will only worsen the situation in the near future. Currently

predicted at best is a slow recovery for the economy, with consumer spending likely to

taper off and growth predicted stuck at 2.5% throughout most of 20035. What is needed to

1 Figures taken from the US Commerce Dept. Bureau of Economic Analysis (www.bea.gov). Estimatesbased on 1996 prices.2 Figures taken from the Economics 116a webpage.3 Inflation rates computed from CPI figures from the Economics 116a webpage.4Economy Faces Slow Growth, Forecast Says, The New York Times, Dec. 5, 02.5Economy Faces Slow Growth, Forecast Says, The New York Times, Dec. 5, 02.
mailto:[email protected]:[email protected]


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prevent recession now is a plan that will have immediate effects in decreasing

unemployment.

PART 2: PROPOSAL

My proposal on fighting the upcoming recession involves the use of both fiscal

and monetary policy. I advise first increasing government spending while maintaining

current taxes, which would increase GDP without affecting public consumption or

savings. Specifically, an increase by $120.6 billion would put the unemployment rate

back to desired levels. Much of the money would be allocated towards increasing

homeland security and foreign military operation spending, topics which currently have

the fixed attention of the nation. According to a recent New York Times article, military

spending in 2002 has increased since last year by $10.6 billion 6; the public has shown

current willingness to accept increases in military budget.

As well as increasing government expenditures, I recommend that the Federal

Reserve tighten the money supply through buying securities on the open market. This

would have the result of lowering nominal interest rates, which would encourage

investment. This will have the added benefit of increasing growth, and allowing us to get

out of our current growth slump, while decreasing the trade deficit.

PART 3: OBJECTIVES

This proposal would accomplish several of the listed objectives, and most

importantly would stave off the oncoming recession. By increasing government spending

without increasing taxes, GDP would increase, creating jobs and preventing rising

6Pentagon's Urgent Search for Speed, Cushman, John. The New York Times, Dec. 1, 02.


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unemployment. Without rising unemployment, the threat of the cycle of unemployment

leading to decreased spending leading to greater unemployment would disappear,

eliminating threat of an economic slump.

Specifically, Goal 1 is to ensure that unemployment is as low as the NAIRU by

the end of the year. Okun's Law, which has been shown consistent with empirical

evidence, tells us that for every three percentage points GDP rises, unemployment falls

by one point. In 2001 the unemployment rate was 5.8%. We want to lower this to the

NAIRU, which is estimated to be 5.2%7, in order to prevent the seemingly imminent

recession. According to Okun's Law, a 0.6% decrease in unemployment will correspond

approximately to a 1.8% increase in real GDP. As real GDP is estimated to be at $9377.8

billion this year, a 1.8% increase would correspond to a dollar increase of $168.8 billion.

From our understanding of macroeconomics we know that an increase in government

spending is multiplied by the open economy multiplier(because the United States

economy is open, and therefore some part of any disposable income gained is spent on

imports) which equals 1/(Marginal Propensity to Save + Marginal Propensity to Import).

Approximating the open economy multiplier as 1.4 for the US economy, an increase of

$120.6 billion in government spending is needed to trigger the effective $168.8 billion

increase. If we increase public spending by that amount, then we should see the quick

decrease of the unemployment rate to the NAIRU.

This increase in government spending, assuming that the majority of it is

allocated to homeland security and military spending, will fulfill Goal 2, which is the

increase of the share of national output devoted to such spending.

7 NAIRU estimate taken from the Economics 116a webpage.


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Goal 3, increasing the growth rate of potential output, will be accomplished by the

proposal, by having the Federal Reserve buy securities, increasing the money supply and

therefore lowering interest rates. This in turn will reduce the cost of investing, therefore

raising public desire to invest by increasing the cost of spending money. The amount of

private savings will increase, which will increase total investment, as Gross Domestic

Investment (I) + Net Foreign Investment (X) = Private Savings (S) + Government

Surplus (GS). This will work towards increasing growth rates.

Goal 4, lowering inflation by at least two percent, will not be accomplished by the

plan. We believe that the current inflation rate of around 1.2% should not fall any lower,

because of the threat of deflation. However, in the near future, there might be a need to

lower interest rates, while maintaining unemployment as close to the NAIRU as possible.

The only way to do this would be to increase aggregate supply. This might be

successfully accomplished by a United States declaration of war on Iraq. The military,

now with larger budget due to increased government spending on homeland security

outlined under Goal 2, could move into the Iraq/Kuwait region to maintain stability. Once

secure, the region would provide a temporary source of oil that could be regulated in

prices and quantity, a source that would provide the needed cuts to supply costs to shift

aggregate supply to the right. This would effectively increase the growth rate of potential

output, aiding in accomplishing Goal 3, as well as lowering prices, i.e. keeping inflation

low.

Goals 5 and 6 are closely related. Goal 5, lowering the trade deficit, means some

combination of increasing exports and/or decreasing imports. This might be

accomplished by a decrease in the exchange rate, i.e. lowering the value of the dollar in

the global currency market, however, Goal 6 is to maintain the strength of the dollar. A


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strong dollar necessarily means that imports will be more than they would be for a weak

dollar, and exports will be less, which means a smaller trade deficit corresponds to a

weaker dollar.

By lowering interest rates as outlined in the proposal, the trade deficit would

decrease, as the price of foreign goods increased in the United States due to a devaluing

of the dollar. This would accomplish Goal 5, imports would decrease and exports would

increase, while maintaining an open economy; there would be no need to impose either

taxes or tariffs to discourage imported goods. A decreased trade deficit, i.e. increased net

exports, means an increased net foreign investment, which aids the achievement of Goal

3, increased growth rate through increased investment. Goal 6, however, would not be

accomplished, as lowering interest rates necessarily devalues the dollar.

Overall, my proposal to use fiscal policy by increasing government (military)

spending and use monetary policy in having the Federal Reserve raise interest rates will

pull the economy out of its current slump. Increasing government spending should be

easy, with control of the Senate and the Whitehouse under the GOP. This will pull down

unemployment rates, and of course, increase military spending. By lowering interest

rates, we will see the accomplishment of lowering the trade deficit and an increase in

growth rate due to increased domestic investment. Hopefully, by implementing this

proposal, we can stave off the oncoming recession and accomplish the majority of the

short-term goals.

Econ 116 Problem Essay 7

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