Many of you are curious to how hard economics actually is at university. This essay below scored 62% and was for half way through my first year! Enjoy!
P.s if you get a chance, check out another essay i wrote for my economics degree after this one! I wrote it live on YouTube (just click the image to head over there!).
Analyse and discuss the consequences of expansionary fiscal policy in an open-economy with flexible exchange rates essay.
"Fiscal policy is the manipulation of government spending and taxation in order to achieve economic objectives. It is often used when an economy is far away from their target trend rate economic growth. The great recession would be a prime example of this as in the UK public expenditure increased (as a % of gdp) by 6%, to a 30 year high, during and after the recession [1]. This was in attempt to stimulate the economy and move the UK back to the 2% trend rate growth target.
In an open economy, trading occurs between that economy and the rest of the world. The volume of trade, within the categories of imports and exports, alters the exchange rate if the domestic country has a flexible system. Essentially the exchange rate is determined by the market forces of supply and demand for their currency (in relation to the supply of other currencies) which Is impacted upon, mostly, by net exports.
With these set conditions (from the essay title) expansionary fiscal policy can impact upon several key economic indicators and factors such as employment, inflation and the investment saving ratio. Paul Krugman stated that he “always believed in expansionary monetary policy and if necessary fiscal policy when the economy is depressed”[2]. Here the use of fiscal policy is evidently portrayed as he implies it is the most efficient way, with the highest chance of success, to boost the economy. However, he also implies that it can have big consequences hence why he only sees fiscal policy as necessary when the economy is “depressed”. This essay will discuss the key consequences of expansionary fiscal policy and analyse the impacts of it upon an economy that adopts such a strategy.
One consequence of expansionary fiscal policy, in the form of a tax cut such as a reduction in a regressive tax like VAT, is that it would increase the amount of real disposable income for domestic households. As real disposable income is positively correlated with consumption, consumption by domestic citizens would also increase. By nature, imports would also increase as imports are a factor of consumption, yet the size of the increase would depend on the marginal propensity to consume and the marginal propensity to import. Due to flexible exchange rates the domestic currency would depreciate as supply of that currency would increase due to people exchanging the currency (supplying it onto the market) it in order to obtain imports (assuming certibus paribus).
The devaluation of the domestic currency reduces the incentive for foreign and migrant workers to get a job in that economy. This is due to the fact that the wage they would acquire will no longer buy as much as it previously would of abroad. This then makes it more beneficial for the workers to look for work in another economy. John Hardman stated “The depreciation in the pound is making the UK far less attractive. Workers from Romania or Bulgaria can go to Germany (…) It is a better alternative for them.”[3]. Therefore, it is evident that fiscal policy would reduce the work force of that economy. Using the UK as an example 11% of the labour market is made up of non-UK nationals therefore the lack of migrant workers could drive up labour costs (as supply of labour would decrease) and negatively affect UK businesses (higher costs)[4] which ultimately would lead to cosh push inflation as costs are passed onto the consumer. Therefore, it is clear that expansionary fiscal policy could lead to inflation in an open economy with flexible exchange rates.
However, contrasting the above point it may be argued that the labour force will remain unchanged after the enactment of expansionary fiscal policy. This is as, although true that the migrant work force may decrease as a result of the policy, the domestic work force will increase and unemployment will reduce domestically. This Is as expansionary fiscal policy would increase aggregate demand and therefore boost output in the economy. As we assume it is an open economy it is likely that the businesses will increase exports. An example to portray this would be executing tax cuts for corporations. These tax breaks/cuts could, in turn, allow them to decrease their prices, making firms more internationally competitive. This would thus boost each firm’s exports (assuming certibus paribus in the economy).
As a result of higher exports the firm would need to hire more workers and in every major world economy there is domestic unemployment. Therefore, in this situation firms would be able to find workers domestically to work for them which would in turn reduce unemployment (firms may have to transfer a percentage of the savings from the tax cuts to their costs to allow them to pay higher wages to incentivise citizens to come and work for them). For example, in order to boost the US economy trump wants to enact expansionary fiscal policy and cut the corporation tax rate to 20% from 35%, - “President Donald Trump has put slashing the 35 per cent corporate tax rate at the heart of his mission to boost the economy and create jobs” [5]. Therefore, it is clear that unemployment In this situation would not increase but decrease. Therefore, expansionary fiscal policy in an economy with the conditions stated could reduce unemployment and lead to longer term economic stability and possibly growth.
Alternatively, it could be argued that a consequence of expansionary fiscal policy in an open economy with flexible exchange rates is that its effectiveness is limited and that it can possibly lead to lower, overall, national output. This is due to the decreasing value of the positive tax multiplier as a consequence of expansionary fiscal policy in an open economy with flexible exchange rates. Expansionary fiscal policy ultimately increases and shifts out the IS curve to the right in an economy. It also shifts out aggregate demand in an economy to the right. This is as government expenditure is a component of aggregate demand that positively correlates to the overall demand of an economy.
Therefore, an increase in government expenditure would increase aggregate demand and increase average price level in an economy. Higher prices mean lower real disposable income assuming wages remain unchanged. This causes the savings of domestic citizens to decrease. As savings are lower economic agents such as the government and banks have to offer a higher reward for saving in order to incentivise citizens to save more which is crucial for the banks as they need the currency to in turn finance loans to initiate economic development. In order to do this interest rates, increase. This is evidently seen on the IS-LM model. When the IS curve increases as a result of higher government spending; the diagram evidently portrays an increase in output on the X axis and an increase in interest rates on the Y axis, in order to incentivise citizens to save more. A consequence of this is that as interest rates increase it multiplies the incentive for non-residential citizens to obtain the domestic currency (as well as domestic citizens to increase their savings). This is as it will be more beneficial, financially, for foreign citizens to invest their financial capital into the economies banks that now have higher interest rates as it would ensure they received a higher, risk free, reward for saving/investing than they previously were receiving. This causes the domestic currency to appreciate as demand for it would increase assuming flexible exchange rates. This would therefore decrease their exports as it is now more expensive for consumers abroad to consume their products as it requires more of the consumers abroad currency to obtain the currency that has appreciated (imports will also increase). This then causes the positive tax multiplier to diminish. This is as the tax multiplier equals –mpc/mps and the marginal propensity to save will have increased due to higher interest rates. Therefore, it can be argued and seen that having a flexible exchange rate system in an open economy could reduce the effectiveness of expansionary fiscal policy and consequently reduce net exports and limit economic development.
In conclusion, it may be argued that expansionary fiscal policy can be seen to have several different effects on the economy. When a single individual base affect is studied it seems to paint a picture of a changing unemployment rate and a changing price level etc (resulting from expansionary fiscal policy). However, when each affect is studied simultaneously (all outcomes of different base affects) it is clear that the majority of the consequences of expansionary fiscal policy (in an open economy with flexible exchange rates) have a counter balancing effect evident by the effects on unemployment in an economy of such policy. However, there appears to be one effect that there is *normally* one consistent throughout each individual consequence of expansionary fiscal policy, regardless of the initial base affect that occurs as a result of the policy. This is an overall increase in economic output. While it appears that for the exchange rate, net exports and other factors it is dependent on the route that fiscal policy takes upon whether they increase or decrease.
It is also evident that the effects of such policy are dependent on the marginal propensity to consume, export and import of an economy. Therefore, not one set of single consequences could define the use of expansionary policy as it is unique to each economy and their economic situation."