The DRI Model of the US Economy, Essay Example

Abstract

The current economic recession being witnessed is impacting many countries; developed and developing alike. Many countries have turned to tax reductions and boosting of government expenditures to mitigate its effects (Barro & Redlick, 2009). This move was first endorsed by Richard Kahn in 1931 who claimed that it can stimulate output significantly (Clarke, 2009). However, economists have doubted the credibility of the move and a heated debate has been witnessed. By evaluating the ideas critically, it is evidential that the ideology overlooks some important aspects such as the government’s economic strengths, type of economy, and the kind of measure implemented.

The current economic recession in the world is affecting many countries; both the developed and the developing. As a result, many countries are mitigating it by cutting taxes and increasing government spending, a move which has sparked a heated debate from a section of economists on its viability (Barro & Redlick, 2009). In support of the move, the G20 group of economists has endorsed stimulus packages for countries to adopt (Clarke, 2009). The debate on the subject usually revolves around the scale of fiscal multipliers first hypothesized by Richard Kahn in 1931. This paper analyzes this controversial ideology of fiscal multipliers and concludes by giving a verdict of the same. It is presumed that other people may have opposing views since the arguments presented in this paper are based on a personal perspective of the issue.

According to Kahn, tax cuts and increases in government spending impact positively on the output. He argues that fiscal multipliers increase government spending and the country’s Gross Domestic Product (GDP) at long run (Clarke, 2009). As an elaboration Kahn argues that with a multiplier of one, government expenditure of $1 billion would increase the country’s GDP by $ 1 billion. This is because the one billion dollars spent would accumulate as income to others who would spend a fraction of it, for instance c. therefore $c will accrue as income to others and the process continues increasing the original $ 1 billion spending (Otto, 1983). This is what he termed as the multiplier. However, the multiplier size varies with the economic condition, type of fiscal action, and the reaction of people to higher government borrowing.

Several studies have refuted or questioned the validity of Kahn’s ideas. For example a study focusing on consumers’ behavior in response to particular tax rebates and cuts reveal that permanent cuts on taxes impact more on consumer spending compared with temporary ones (Souleles et al, 2006). This implies that temporary tax cuts can fail to achieve the multiplier effect even it the government increases its spending. Another study reveals that closed and open economies function differently since the multiplier is affected by foreign trade (Al-Eyd & Barrell, 2005). In closed economies multipliers are bound to be bigger since less of the stimulus leaks abroad through imports. According to this finding, the government may increase its spending but due to rampant importing trade in open economy, the multiplier effect may not be achieved since the stimulus will leak abroad through the imports. There is also existing empirical evidence revealing that the response of real GDP to increased government spending and tax variations are thin (Al-Eyd & Barrell, 2005).

When trying to test the statistical impact changes the government spending or tax cuts have on GDP using accrued empirical data, it is challenging to isolate the effects the effects of fiscal stimulus measures from the increase in social security spending and reductions in tax revenues that accompany recessions naturally. This means that during recessions, the multiplier effect may be challenged by other factors and increasing government spending or reducing taxes may not play the trick. On the other hand, multipliers are different in developed and developing countries. In developed countries, they are bigger whereas in developing countries they are affected by flocking investors who increase the interest rates. Therefore developed and developing countries should not be gauged on the same level ground. Lastly, government spending varies with time. For instance, wartime spending is large and independent of economic development. Such spending cannot be considered positive as a multiplier.

The economic recession is a hard reality to accept but the fact remains that it is real and actually facing the whole continent. Countries have tried to face it through cutting taxes and boosting government expenditures but the viability of the moves has been doubted from several quotas of economists. As suggested by Richard Kahn in 1931, these moves can stimulate output. However, a critical analysis reveals that the moves can be affected by other factors among them the country’s status (developed or developing), type of economy (closed or open), and the form of government spending.

References

Otto, E. (1983). The DRI Model of the US Economy. New York:McGraw-Hill

Souleles, N., Johnson, D., & Parker, J. (2006). Household expenditure and the income tax rebates of 2001.  American Economic Review, 96: 1589–1610

Al-Eyd, A. J., & Barrell, R. (2005). Estimating tax and benefit multipliers in Europe. Economic Modelling, 22: 759–76

Barro, R. J. & Redlick, C. J. (October 1, 2009). Stimulus spending doesn’t work. The wall street journal, 1-2.

Clarke, H. (2009). Fiscal multipliers. Retrieved October 9, 2009, from http:/www.harryclarke.com/2009/10/04/fiscal multipliers/