Overheating economy in China
Lu Lu (6500354)
How successfully can fiscal policy be used to combat (a) recessions and (b) 'overheating' in the economy? Use examples and evidence to support your arguments.
Business cycle is defined as the alternating periods of expansion and contraction in an economy’s real output (Welch, 2004: 146). Rather than occur randomly, business cycle tends to be regular which goes through four phases: a recovery during which real GDP increases; a peak where maximum output occurs; a recession during which real GDP falls; and a trough where minimum output occurs (ibid.). There is undoubted those economic fluctuations have influential effects on societies. Fiscal policy, which is the governmental policy used to intervene in the macroeconomics by the overall level of government purchases and taxations, is one of the most important policies used to maintain the stabilisation of the economy (Case and Fair, 1999: 583). Recession and overheating can be seen as the main targets that the fiscal policy tends to deal with (Mankiw, 2005: 723). Critically, it seems to be successful to combat recessions and overheating by fiscal policies, but there are also several limitations.
Recession is a period in which the economic growth rate is far below the normal, according to Frank and Bernanke (2004: 645). During a recession, people have fewer stimuli to consume and invest, and the unemployment rate tends to rise rapidly. The causes of recession seem to be complicated. Keynes (Schiller, 2005: 265-267) has developed a theory that pays attention to the demand-side. In his view, people’s expectation plays an important role in short-run recession. If people tend to be more pessimistic about the future, the economy, therefore, is likely to suffer a recession (Mankiw, 2005: 732). In order to overcome this demand-pull recession, the government should implement an expansionary fiscal policy by either increasing the government expenditure or reducing the taxes in order to stimulate the investment and consumption. (McConnell and Brue, 2002:225). Illustrate an example of intense recession in US 2003. Concerned about the deflationary gap, President Bush advocated a tax cut of 100 billion US dollars in 2003 and a further 670 billion cut over the ten years (ibid.). Meanwhile, the federal government spending had reached to 20,000 US dollars per household, the highest level of federal spending since World War II (Riedl, 2003). As a result, the GDP growth rate was 5.4 percent during the three quarters after its passage, compared to -1.81 percent before the cut tax, while the unemployment rate dropped by 1.0 percent (Beach, et,al. 2004). It is clear indicated that the federal government has been successful in combating with the recession by expansionary fiscal policies.
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Although expansionary policy seems to be a good approach to fight with recession both in theoretic and empirical dimensions, there are many critiques about its effects in reality. One argument is the time lags. According to Miller (2001: 308), these lags can happen during the time of recognising recession, the time between recognition and policy implementing and between the implementing and effects. Another argument is the trade-off between short-run and long-run effects. According to Weil (2002), expansionary policy may lead to higher output today but lower the productivity below what it would have been in the future. In his further explanation, operating a budget deficit caused by expansionary policy entails a decrease in national savings, which is the determinant of future economic growth, and lower saving means the government will either invest less in capital or increase foreign loans, both of which may lead to unpleasant consequences in the future.
The most famous argument is crowding-out effect, which has criticised that an expansionary fiscal policy will increase the interest rate and encourage savings, thereby weakening the stimulus of expansionary policy (McConell and Brue, 2002: 234). It is clear that the government should increase their spending as well as cut the tax to stimulate the investment and consumption when during recession, thereby leads to a further budget deficit. The government, therefore, must search for more loans to fill the gap in budget, which drives the money demand curve to the right. As a result, the interest rate was increasing, as illustrated in Figure (a). However, as McConell and Bure (2002: 234) argue, the policymakers can eliminate the crowding-out effect by increasing the quantity supply of money which can offset the deficit-caused increase in the money demand to keep the interest rates unchanged, as illustrated in Figure (b) (ibid.).
In addition to Keynesian theories, there is an alternative economic school emerging recently, who argues the demand-side policies seem to have limited effects when the recessions are caused by the aggregate supply (Schiller, 2005: 268). Changes from labour, capital, resources and technology can be the causes of supply-side recession. Besides, suppliers’ expectation also plays an important role in shifting the aggregate supply. Therefore, the government should use supply-side policies, such as cuts in marginal tax rate, to alter the incentives and abilities to produce goods and services (ibid.). The Reagan tax cut in 1981 was one of the most famous examples. By reducing tax rates on wages and profits, the Reagan tax cut sought to stimulate the willingness to supply goods (Schiller, 2005: 268). Besides of tax stimulus, the government can alter the aggregate supply by education, training programs, and immigration polices in a long run (ibid.).
Compare to demand-side policies, supply-side theory seems to be more attractive because the policymakers can achieve the goals of reducing inflation and raising real GDP at the same time—as shown in Figure (c). However, this ideal situation seems to be hard achieved in reality. Despite problems of time-lag and crowding-out effect, there are several critiques concerning that the supply-side policy might be useless in short-term fluctuations. Ballmol and Blinder (2000:613) hold an argument it is not easy to alter the determinants of aggregate supply –such as capital, labour and technology—in short terms. Even though the suppliers’ expectation can be changed immediately, it only has limited effects to shift the curve. However, the supply-side policy can have an absolute impact in the long-run economic growth, as Bartlett (2007) argues. Therefore, supply-side policy is often described as a growth policy during the overall economic trends while demand-side policy is often used to maintain the economic stability in short-run.
So far we have analysed the policies to fight with recession, here it will turn back to Keynesian theories to consider an overheating situation in the economy. Overheating is the period that economic growth rate is far above the normal, which causes an expansionary gap between the natural rate of output and aggregate demand (Frank and Bernanke, 2004: 645). The causes of overheating can be either consumption-pulled or investment-pulled, both of each will push the economy into a much hot but also danger situation, considered by Begg and Fischer (2003). An overheating situation typically results in increased inflation, which reduces the efficiency of the economy in the future (Frank and Bernanke, 2004: 646). According to Keynesian theory, when the economy faces demand-pull inflation, a contractionary fiscal policy can be implemented by either decreasing government spending or raising taxes (McConell and Brue, 2002). US government, for instance, increased tax and slowed down the government spending during the beginnings of 1990s in order to slow the rate of economic growth and keep inflation in check (Schiller, 2005).
This contractionary fiscal policy, which appears to be reasonable in an economic model, however, might be useless in the reality. Despites the critiques of time lags and crowding-out effect mentioned previously, many economists recently argue that an overly harsh contractionary policy may cause the problems of rising unemployment rate and economic depression (Naughton, 2007: 443). China, however, tends to combat an overheated economy by a ‘soft-landing’ approach, without an intense fluctuation and rapid growth in unemployment (Roach, 2006). Due to the active expansionary policy since 1998, China have been the third economic entity in the world but also suffered the problems of overheating. As Ignatius (2004) argues, some industries have over-invested while others, such as agriculture, still have low development. For example, the investment in the steel industry grew 96.6 percent in 2003. In addition to the traditional way of cutting government expenditure in infrastructure, the central government also tends to adjust the economic structure by keeping down the over-investment in several industries and prompting other less-developed sectors, such as agriculture, education and social security (Xu, 2004). This so-called ‘neutral fiscal policy’ seems to be successful to cool the overall economy with an objective of a gradual elimination of inflation and overall price stability (Naughton, 2007: 443).
It is not easy to draw a conclusion that whether fiscal policy is successful or not to combat economic fluctuations, since both the demand-side and the supply-side theories tend to be useful to some extent but also have many shortcomings, such as time lags, expectations, and crowding-out effect. Besides, the policymakers have to trade-off between the short-run benefits and long-run effects in order to achieve the goal of long-run economic strategy. Definitely, the real world economy is much more complicated than which are described in the economic model. Some nations, such as China, still have many problems in their less-developed market-based economics, and the use of pure fiscal policy seems to be little influential and effective in adjusting the economy in short-run. Even in well-developed market-based economic entities, the best approach they choose is to use the combination of fiscal and monetary polices to combat the economic fluctuation and maintain the economic stability. Therefore, it is undoubted that the most appropriate way to achieve an overall economic stability is to use the combination of fiscal and monetary policy to manage the short-run fluctuation and use the supply-side policy to achieve the long-run trends.
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