Prior to the Great Depression, very few people would agree with the statement that the government can substantially impact the market. Nowadays, very few people would disagree with it. Monetary and fiscal authorities wield the most powerful weapons for shifting economic landscapes of a country. These weapons include but are not limited to, currency inflation, interest rates, bailouts, subsidies, tariffs, regulations, and corporate tax (Beattie, n.d.; Gwartney, Stroup, & Sobel, 2014).
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Unfortunately, policies implemented by the government in order to achieve a short-term economic boost can send shockwaves through the market, thereby undermining businesses and even industries. The aim of this paper is to analyze the impact of fiscal policies from Keynes to the present day. The paper will also discuss the effectiveness of government intervention in market failures.
Until the Great Inflation (the mid-1960s through the 1970s), Keynesians and many other economists held the view that the government could use a combination of fiscal and monetary policies to stimulate demand, thereby reducing unemployment and achieving economic growth (Bryan, n.d.). Keynesians believed that “there was a stable inverse relationship between inflation and unemployment” (Forder, 2014, p. 27). This view was based on a set of observations dubbed as the Phillips curve. The intellectual consensus of economists of that era pushed policymakers to pursue the most favorable relationship between the two variables.
The application of the Phillips curve to the economic crises of the 1970s was based on two assumptions (Hetzel, 2013). The first assumption is that inflation is caused by a wide range of factors, none of which falls under the rubric of monetary control failure. The second assumption was that economists understood full employment and unemployment rates sufficiently well to exploit the trade-offs between unemployment and inflation (Hetzel, 2013). Therefore, policymakers wanted to introduce the stimulative monetary policy in order to decrease the levels of unemployment.
At the heart of the Keynesian model of economics was the belief that “without the management of aggregate demand by the government through deficit spending, output and employment can fall short of potential output overextended, perhaps indefinite, periods” (Hetzel, 2013, p. 91). Keynes’ central objective was full employment, which, he believed, could not be achieved without intervention by central banks (Cioran, 2014). Policymakers of the Great Inflation era applied the Phillips curve to predict the cost of inflation during the pursuit of full employment.
Monetarists such as Milton Friedman opposed the policies championed by proponents of the Keynesian model (Gwartney et al., 2014; Wood, 2014). Friedman was proved right when the application of the curve resulted in the stagnation of the 1970s and double-digit inflation (Hetzel, 2013). Despite the fact that the outcome of the Great Inflation confirmed predictions of the economist, debates on the validity of the curve continue.
In the wake of the crisis, Paul Volcker was appointed as Fed chairman in order to decrease the level of inflation which reached 13 percent by 1979 (Sargen, 2016). Therefore, an anti-inflationary monetary policy was adopted by the Federal Open Market Committee, which has led to two recessions in 1980 and 1981 (Bryan, n.d.). However, the recessions were followed by the reduction of the rate of inflation to 3 percent (Bryan, n.d.). The improvement was achieved by reducing the Fed’s target rate of inflation that precipitated a decline in output and a high real interest rate in the short run and lower inflation in the long run.
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In 2001, interest rates were lowered again in order to fight a recession (Sargen, 2016). In an attempt to increase the rate of recovery the federal funds rate was lowered to 1.25 percent in 2003 (Sargen, 2016). It was also done to prevent aggregate demand from falling. The policy was effective because it helped to stabilize inflation and increase output.
Quantitative easing (QE) is an umbrella term for a set of policies directed towards the stabilization of the financial market. During a recession triggered by the financial crisis of 2007-2008, the central bank purchased government bonds, thereby increasing the supply of money in the economy (Joyce, Miles, Scott, & Vayanos, 2012). As a result, financial institutions reduced interest rates, which increased lending.
Even though QE is an effective tool for solving liquidity challenges, it is associated with a major drawback of the depreciation of a country’s currency, which increases the price of imported goods. Despite this drawback and considerable quantitative challenges, the use of the instrument was effective during the crisis and the post-crisis period in lowering interest rates (Joyce et al., 2012). However, the use of QE proved to be inefficient in promoting economic activity. It has to do with the fact that the tool “sends a powerful signal of economic pessimism to market participants” (Putnam, 2013, p. 7). In addition, the long-term economic cost of QE is excessively high.
Market Failure Correction
Market failure refers to a situation in which the competitive outcomes of markets are inconsistent with economic efficiency (Gwartney et al., 2014). Unfortunately, attempts to address market failures often result in government failures, which are situations that hinder economic efficiency.
When the normal functioning of the market is not aligned with policymakers’ assumptions about the efficient allocation of scarce resources, politicians create demand for government intervention. Neoclassical welfare economics rests on two presumptions, the first of which is that the market process is a way to attain Pareto-efficiency (a state in which a person cannot achieve further gain without worsening a situation of another actor) (Florio, 2014). Another presumption is that the state of Pareto equilibrium can be achieved via corrective measures.
The government creates demand for such corrective actions by stressing that lack of competition, information asymmetry, and externalities are harmful to both the economy and public interest. Even though it is correct, interventions can bring about new externalities. For example, in an attempt to increase the number of mortgage applications, the government has precipitated the crisis of 2007, which is a classic example of government failure (Keech, Munger, & Simon, 2012).
Government-sponsored entities Fannie Mae and Freddie Mac guaranteed mortgages at unsustainably low market rates (Keech et al., 2012). Furthermore, bank bailouts generated wrong incentives, thereby stimulating excessive risk-taking. Even though the crisis was largely a result of governmental intervention, it was blamed on market failure.
Another case in point is rising health care costs, which are also explained by the market failure even though the problem has been caused by the absence of the market (Lee & Clark, 2013). In order to create demand for corrective government actions, interventions are portrayed as those that unlike greed-driven market activities are guided by “concern for the public interest” (Lee & Clark, 2013, p. 289). Such explanations are extremely appealing; therefore, they always generate public support.
The paper has analyzed the impact of different fiscal policies and discussed the application of the Keynesian model. The paper has also explained how the government creates demand for corrective measures.
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Bryan, M. (n.d.). The Great Inflation. Web.
Cioran, Z. (2014). Theories of monetary policy: From the mercantilist pragmatism to the modern monetary theories. The USV Annals of Economics and Public Administration, 14(1), 92-101.
Florio, M. (2014). Applied welfare economics: Cost-benefit analysis of projects and policies. Abington, England: Routledge.
Forder, J. (2014). Macroeconomics and the Phillips Curve Myth. New York, NY: Oxford University Press.
Gwartney, J., Stroup, R., & Sobel, R. (2014). Economics: Private and public choice (15th ed.). Mason, OH: South-Western College Publishing.
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Hetzel, R. (2013). The Monetarist-Keynesian debate and the Phillips curve: Lessons from the Great Inflation. Economic Quarterly, 99(2), 83-116.
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