Another one of these reasons is the global credit crunch. Banking systems of each country are linked internationally. Therefore when some banks began losing money, they became hesitant about lending money to others. This resulted in banks stopping to lend to each other and therefore a shortage of money supply in the world. As a result it became more difficult for firms and consumers to borrow money from banks. This decrease in bank lending resulted in a fall in aggregate demand worldwide. (The Associated Press, 2009)
Global trade is major reason for the spread of this financial crisis. Due to the accelerated levels of globalisation, the global economy has become more integrated and countries are so much more dependent on each other and on one another’s exports and imports. As the US entered the recession, their demand for other country’s exports fell. Basically other countries were generally exporting less, which could result in larger deficits on their Balance of Payments Accounts. The financial crisis has now spread to these other countries. (Quiggin, J. 2009)
Problems in both the financial and banking sectors affected confidence of consumers and firms. Overall the confidence of global consumers decreased as all the banking sectors were experiencing great loss and consumers and investors grew sceptical about the future, and how they would spend their money.
Every single EU country has been affected by the financial crisis. Each country that wishes to survive this crisis is cutting back on spending and borrowing and making long term plans in order to survive. In August of 2009, research showed that the European area’s overall GDP had declined by 0,1% which was a much smaller drop than expected. The large economies of France and Germany both grew by 0.3% while other rich economies such as Britain and America were shrinking. France and Germany believe that trade contributed to the increase in GDP and “thanked” Asia for their increase, due to Asia’s recent export revival. Both Italy and Spain’s GDP shrank by between 0,5% – 1%. Italy is facing high public debt and therefore the government is unable to provide support.
Countries such as Belgium, Austria and the Netherlands who are very open to trade were shrinking, while Portugal and Greece were growing. France has proven to be a big exception to the shrinking economies of the EU. France has suffered a lot less than most countries and it is believed that this is due to their efficient government. (The Economist, 2009)
Latvia and Lithuania have been named the worst hit countries in Europe and their economies have shrunken to almost a fifth of their initial size before the financial crisis began. (Beetsma, M. 2008) Poland and the Czech Republic are suffering with large fiscal deficits that could jump to more than 6% of GDP in 2010 due to a fall in tax revenues and rising social costs. Hungary and Romania find themselves in the same position. (Winfrey, M. 2009) Consumer confidence in Germany has improved as signs of economic improvement are arising. (The Associated Press, 2009)
The region of Europe that was one named the “sub prime of Europe” has experienced a decrease in western bank loans, exports, investment and consumer spending and increase contractions in almost every country. European countries are facing a weak demand for their exports, increasing unemployment, large public debt and budget deficits. (Winfrey, M. 2009)
Given the current economic position that South Africa is in, we would choose to recommend a contractionary fiscal policy to the Minister of Finance. The Government is approaching a budget deficit and the use of the fiscal policy will help correct that. A government budget deficit occurs when government spending is greater than their tax revenue. A contractionary fiscal policy is used to decrease the level of spending in an economy. This can be achieved by increasing the tax levels, which will result in a lower level of spending, output and income. This decreased level of spending can also be used to curb high inflation levels. (Le Roux, W. and others. 2007. 57-59)
An increase in taxes will lead to a decrease in disposable income to consumers, as they now have to pay a higher percentage of their income to the government via taxes. This results in a decrease in consumer consumption and spending. The consumers can no longer buy the same amount of goods and services as they were before as their disposable income has decreased. With a contractionary fiscal policy, Government will decrease their spending. This decrease in government spending combined with a decrease in consumer spending leads to an overall decrease in aggregate demand. Therefore there will be a shift of the aggregate demand curve to the left. This will lead to a decrease in prices in the short run. This decrease in prices will result in an eventual increase in exports as our goods and services will now be cheaper for foreigners to purchase. (Parkin, M. 2008. 642-644)
However it is vital that the tax rate is not increased too much, as a very high tax rate will not only lead to a decrease in consumer consumption and spending, but it will lead to slower production as workers are less motivated to work as hard as the majority of their money becomes taxes. This might lead to a decrease in economic growth.
In addition, we would suggest that the Reserve Bank implements a contractionary monetary policy to increase interest rates. There will now be less money available for commercial banks to lend to consumers and firms and credit becomes more expensive. A trade-off of increasing the interest rates is that consumers will decrease their amount of spending as it has now become more expensive for them to borrow from commercial banks. Consumers will want to save more due to the higher interest rates. On the other hand, an increase in interest will result in an increase in investment as foreign investors will want to invest more money into South Africa as they will receive a higher return on their investment. An increase in investment will lead to an increase in the quantity of capital in the country as well as technological advances, which will increase potential GDP. An increase in potential GDP will increase aggregate supply therefore shifting the aggregate supply curve to the right. (Parkin, M. 2008. 638-640)
The above changes in aggregate demand and aggregate supply are shown in the diagram below.
AGGREGATE DEMAND AND SUPPLY
Price level
Real GDP
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