Macroeconomics essay

The Importance of Public Policy on Economic Activity

The public policy on economic activity is a crucial part of keeping an economy afloat and achieving a functional government regardless of the economic system in Macroeconomics. The role of government in determining standards for economic sustainability, inflation management, and unemployment targeting is not an easy undertaking. To find a balance for the goals of everyone involved, private economic activity must collaborate with public economic activity.

The Role of Fiscal Policy

Fiscal policy is the government’s annual economic plan. It describes the government’s spending and taxing policies. Fiscal policy is an indicator of government priorities and focus for the time period in question. The fiscal policy is governed by political and national agenda as set by a sitting administration with the counsel of the Federal Reserve and other financial stakeholders. The Fiscal policy has to augment the monetary policy as presented by the Federal Reserve Chairman.

The Objectives of Fiscal Policy

The Macroeconomic goal and more specifically fiscal policy is concerned with three general objectives namely; Production, employment and inflation. It attempts to improve production in such a way as to create employment without the unintended consequence of increasing inflation. To this end, policy makers are watching the components of economic expenditure. These are consumption, investment, government expenditure, and net exports. The effort to influence the economy using public spending and taxation is essentially fiscal policy.

The Targets of Fiscal Policy

The three targets of fiscal policy are a summary of the basic economic goals of a country which are economic growth, full employment, price stability, balance of payment, economic security, economic freedom, economic efficiency, economic equity, and economic stability. Achieving these goals requires a robust fiscal strategy that is effective in economic transformation but sensitive to the economic activity of private citizens and firms. It is in trying to accomplish this delicate balancing act the idea of crowding out is born.

The Crowding Out Effect

The crowding out effect is an economic theory that aggressive and determined economic theory has the outcome of pushing down and eventually eliminating private spending in the economy. The fiscal policy is mainly funded by taxation which is paid by private citizens and businesses within an economy. An increase in public spending entails an increase in the tax charged or collected from other economic players. It argues that there is generally stifled private spending in areas were government spending was high. An oftentimes neglected clarification is the condition ’if’ and not ’when’. If an increase in govern demand ’fails’ to stimulate the economy, then the private sector is said to have been crowded out.

Monetary Policy and Crowding Out

Similarly, other researchers have approached the subject of crowding out from the monetary policy angle where an increase of interest rate by the Federal Reserve will most likely cause a reduction in private investment spending further leading to the dampening of the overall investment spending in the economy. In all fairness, hiking interest rates usually is a regulatory measure to hold back on the amount of money in circulation and curb the likelihood of inflation. Though a few authors have opposed this perspective that the crowding out effect as seen with monetary policy has a more intended consequence unlike the fiscal policy scenario, the causality and transmission mechanism of the theory consolidates its usefulness.

Examples of Crowding Out

Another idea of crowding out has been witnessed when the government enacted health care reform that was intended at covering those without medical cover until those with private medical insurance start shifting to using the government medical scheme.

Policy Making and Academics

This idea has relevance in two important areas i.e. policy making and academics. While many consider these two to be a theory versus practical comparison of analyzing a matter, significant parallels can be drawn in understanding the relevance and validity of the crowding out effect in real life. To understand the sequence of the crowding out effect, the IS-LM curves are used as an analytical framework as they have been for multiple macroeconomic theories. The IS-LM curves have obvious weaknesses, but for imagining the practical events, they are ideal pedagogical instruments.

Analyzing the Crowding Out Effect

Academically, the crowding out effect can be analyzed in real or nominal terms. If an expansionary fiscal policy financed by taxes or debt whilst prices are held constant as typical of IS-LM curves, there will be no lasting effect on real income. Equally true is the notion that crowding out means government spending with unfixed prices and constant money supply has no long term effect on nominal money supply. This is off course working through the government spending multiplier.

Government Spending and Private Demand

In simpler terms, government spending predictably displaces the exact amount of private spending. A $1 increase in government demand will lead to slightly more or less decrease in private demand in the short to medium term. Although the aggregate demand may increase in the short term, the tax multiplier effect will quickly dispel the increase in the government demand from the aggregate demand.

Perspectives on Crowding Out

Milton Friedman, an economics scholar, made an initial theoretical analysis of the effect of crowding out. He stated that when investigating the concept of the crowding out effect, it was important to understand the initial and subsequent actions of fiscal policy. Initially, an expansionary fiscal policy may register as a rise in output but in financing the budget deficit, the government will set in motion counter expansionary forces through subdued private spending. Keynes referred to crowding out as displacement rather than decrease. His understanding of the crowding out effect was based on the economy being in ’equilibrium’ and that market forces were responsible for evening out the disturbances caused by an expansionary fiscal policy. Followers of Keynes that include Barro, David, and Scadding produced a paper supporting this view but focusing instead on the ultra-rationality of government and the private sector.

The Validity of the Crowding Out Effect

Their views are widely adopted in academic circles although they both have strong critics who argue that the concepts they had presented of government financing were inconsistent with LM-IS curve assumptions. This led to the adoption of statistical methods to collaborate the academic assertion of crowding out by using econometric models to prove the validity of this economic theory. Though disparities of the regression have been identified from time to time, the cause and effect is now widely accepted by academics and policymakers alike.

Minimizing the Crowding Out Effect

In my observation, economists have adopted different financing models that minimize the impact of the crowding out effect. Consider ’bubbles’ in different sectors. In most cases, the government is not responsible for the rise and decline of those asset’s prices. This builds a case for other disturbances to the decrease in private sector spending. It is possible for an expansionary fiscal policy to occur without depressing private spending. After the 2008 financial collapse, stimulus packages and expansionary fiscal policies induced private spending instead of stifling it as stated by the crowding out effect.

The Relevance of the Crowding Out Effect in Daily Life

The concept has value for our daily lives as it compels us to look more closely at the causality of our decisions, especially those with good intention. Financial growth and investment require diligence and an economic understanding of the potential risk and impact of personal and federal policy on our wellbeing. While most decisions are routine and without catastrophic risk, the crowding out effect gives us a reason to look more closely at our actions for unforeseen or potential long-term consequences to prevent economic recession.

References

Davies R, 2015, Economics; making sense of the economy, The Economist New York

Carlson K & Spencer R, 1990, Crowding out and its critics

Willem H. Buiter, 1976, Crowding out and the effectiveness of fiscal policy, Econometric Research Program