Markets and Economy, Research Paper Example

Explain how an increased federal budget deficit resulting from a recession can actually help stabilize an economy.

In order to understand how a federal budget deficit, resulting from a recession, can actually help stabilize an economy, one first must understand the differences between the short and long-term consequences, and how those differences might actually signal differences in economic policy. It should also be stated up front that there is no monetarist interpretation of how a federal budget deficit would actually stabilize the economy; indeed, the underlying assumptions of this question point to a Keynesian interpretation of  how (deficit) spending during a recession could help stabilize the economy over the long-term.

Let us put forth an example where an economy has entered recession and wants to get back to the full employment equilibrium.

Looking at the above graph, the recessionary point would be at y1, p1, to the direct left of the full employment equilibrium.  The question then arises: how does the economy get back to the previous equilibrium?  The Keynesian answer is that this type of recession is caused by a lack of aggregate demand- that is, demand as a function of consumption and investment in the economy.  The lack of aggregate demand could be due to a number of external shocks, but the policy path back to equilibrium must be driven by an increase in the aggregate demand.  If, as is usually the case during a recession, there is a lower level of private aggregate demand, and the government needs to add demand n order to push the economy back to equilibrium (y2, p2) on the graph.

The government accomplishes this through a more active fiscal policy; that is, through government spending on projects that increase employment, and eventually return the economy back to its pre-recession state.  In order to understand how government deficit spending might accomplish this, it is important to note that during a recession, a government’s revenue streams (taxes) usually decreases along with a decrease in economic activity; thus, in order to pay for the projects necessary to revive the economy, the government needs to borrow (deficit funding).

Although there are various nuances to this argument, under Keynesian assumptions, if the government does not borrow to increase spending and make up for lost aggregate demand, there is no way for the economy to recover in a short-period of time.

Describe how adjustments in wages and prices take the economy from the short-run equilibrium to the long-run equilibrium.

As with the other questions, this question must be interpreted in the correct context.  In the Keynesian schemata of economics, prices and wages are “sticky” in the short-run.  This essentially means that prices and wages might not react immediately to attendant changes in the market: That is, an increase in aggregate demand should increase prices, and by extension, wages in a stagnant economy.  These prices, however, might not immediately increase due to externalities or other problems in the product or labour markets.

Thus, in the short-term, prices are said to be “sticky”- and if prices and wages change they are said to do so over the long-term as it causes a change or shift  in the demand curves.

Explain why a system of marketable pollution permits leads to less costly pollution abatement and a higher concentration of polluted areas than a command-and-control system?

The question of what type of administration system (government versus market) ultimately leads to a more efficient system of pollution is heavily debated. Before looking at how a market-based system would function, a more extensive look must be given to the problem being solved.

Pollution is typically referred to as a negative externality- that is, firms pollute more than they should if the costs of pollution were adequately factored into their production decisions (social costs> private costs). Thus, policy makers (and economists) have devised two ways to cut down the level of pollution- in economics it is referred to as “internalizing” the externality: 1) government regulation of pollution (alone); 2) a mixed government- industry hybrid that focuses on market solutions to the crisis.

Under the government regulation solution, the government would regulate pollution at a certain level for industries and factories.  This is typically referred to as “top-down” or “command and control” regulation in that the government sets a level of “acceptable” pollution and then enforces the law.  On the firm side, firms may still want to pollute- indeed, some firms may calculate that even with the fines associated with pollution, the production of pollution may still make economic sense.  Under the “command and control” system, however, there is no way to adjust the fines and system away from firms that pollute versus firms that continue to pollute.

With this background in mind, the second solution is typically referred to as “cap and trade.”  Under a cap and trade system, an administrative actor (not necessarily, but usually related to the government) issues permits to firms that pollute based on a certain price: The logic is that firms will use their existing permits, purchase more, or sell extra permits based on the economic price of pollution established by the market.  This is a key difference between the “command and control system” versus the market system: Under government regulation, the price for pollution is likely established be a combination of input from the executive and legislative branches that does not reflect the market’s pricing.  Under the “cap and trade” system, however, the pricing and distribution and permits is based on market pricing- that is, how much firms want to pay in order to pollute.

Thus, a market-based system such as “cap and trade” leads to less costly pollution abatement and a higher concentration of polluted areas.  The distribution of pollution permit can lead to less costly pollution abatement in that the market is setting the price rather than administrative actors.  Of course, this statement depends on the assumption that a price generated by market participants is cheaper than an administrative one; certainly not true in every case, but potentially true in a majority of cases.

Regarding the second condition, a pollution permit system might lead to a more concentrated area due to the general architecture of regulation.  That is, regulation is usually based on only allowing a certain amount in an area- this was the case with gases and other pollutants.  The government mandated that pollution levels could not exceed a certain level on a per county basis.  This type of “geographical” restriction, however, would be eliminated under a market based system that focused on allowing pollution wherever the firm was willing to pay for the pollution permit.

The debate between whether aggregate GDP adequately explains a country’s economic condition has come into focus during the recent recession.  This is because although GDP is one measure that attempts to measure all of the goods produced in a country, it leaves out other (arguably) more relevant measures.  In particular, there are three suggestions that might make the GDP measurement more representative of a country’s overall well-being. 

A combination of the youth and total unemployment rate would be the first indicator included in the index. GDP, as an indicator of economic well-being, simply looks at how much was produced in a certain time period versus the previous quarter or previous year.  Although one could make inferences about the economy’s health based on changes in aggregate output, such as a substantial decrease indicates a worsening economic condition,  there is no way to truly understand how the economic situation is impacting individuals.

Thus, an indication that included the overall employment rate, including the employment Soan additional consideration to understanding the country’s economic condition.   For example, a country’s overall aggregate output may be increasing while the unemployment rate ( particularly among the youth) was also increasing.  These two statistics, however, are indicating two asymmetric trends: the increase in aggregate GDP is intimating economic growth, while the increase in unemployment is intimating greater economic instability.

Another important indicator may be one that measures the burden of disease of population. Although this would be a much more complicated process to calculate than GDP, it would provide key insight into the country’s overall health.  For example, I would propose that two different health statistics be aggregated into one: 1) infant mortality rate; 2) overall mortality rate. Although one could argue that other statistics might warrant inclusion into the measure such as cancer survivorship rate, such statistics are difficult to calculate and even more difficult to interpret.  This new measure, known as “health well-being”, would be included in the GDP figures to understand the trajectory of a country’s health care system.

The third and final indicator to be included in the traditional GDP measure would be a surveyed measure of “happiness.” The measurement of happiness, while a controversial issue in itself, has been proposed in several European countries such as England and France.  The precise methodology behind measuring happiness is difficult to understand (let alone explain), but most agree that a survey would be given to citizens with questions attempting to operationalize their current level of happiness: the concept of happiness would be assessed both on an absolute basis (current status) and a relative basis  (current versus past happiness).

References:

Baumol, W & Blinder, A.  (2008).  Economics Principles and Policy.  Cengage: Boston.

Krugman, P. (2003).  Economics.  Cengage: New York.

Mankiw, G.  (2002).  Economics.  South-Western Press: Boston.

Samuelson, P. (2004).  Economics. Mc-Graw Hill: New York.