ECO511 Economics For Business

Question:

How can governments reduce unemployment using monetary or fiscal policies?

What makes such an action a bad idea.

Answer:

Introduction

In order to stabilize an economy, the governments may use both fiscal instruments and monetary tools.

In times of low demand, expansionary policy is used. These include tax cuts, reductions in interest rates and increases in government expenditure.

However, government can use contractionary strategies when the economy heats up (Sloman Wride &Garratt, 2015).

This article examines the role of fiscal and monetary policy in reducing unemployment.

Monetary Policy

Lowering the Bank Rate

The bank rate is the interest rate at which the central banks lends money to commercial banks.

This policy plays an important role in determining the quantity of money in the economy.

The bank rate is lowered by the central bank to encourage commercial banks and other financial institutions to borrow more money when the central bank wants increase the level in employment.

This will encourage the public to borrow more money by encouraging commercial banks to lower their lending rates.

This will lead to an increase of consumption, which in turn will result in increased investment and expansion of businesses (Mankiw (2014)).

Employment will increase through the establishment and expansion new firms, and thus a reduction of unemployment.

Figure 1: Source : Business Insider

Since the Global Financial Crisis (GFC), the Reserve Bank of Australia made significant cuts to the cash rate.

Australia’s cash rate in 2007 was 7.25%, before the GFC.

When the 2008 crisis began, however, the Reserve Bank of Australia cut the cash rate down to 3%.

Along with other fiscal instruments and policy actions, Australia was able to avoid recession. This helped protect the citizens from the huge loss of employment that is common in advanced countries.

The current cash rate is currently 1.5% (Scutt 2017).

These dramatic cuts in the cash rates have had a substantial impact on different parts of Australia’s economy.

The low cost of borrowing is partly responsible for Australia’s current housing boom.

There are many opportunities for employment as more homes are being built.

Open Market Operations involves the central bank purchasing and selling government securities.

The central bank purchases government securities when it wants to increase the employment rate in the economy.

This raises the reserves of commercial banks and allows them to lend more money.

In turn, the public’s consumption and investments increase which in turn creates more jobs.

In times of low demand, the government purchases securities to encourage economic growth and job creation (RESERVE BRANK OF AUSTRALIA 2013, 2013).

The graph below, graph 2, shows the effect of an expansionary monetary policy on an economy.

The expansionary policy boosts consumption and investment, which leads to an increase in aggregate demand.

The shift of the AD curve between AD and AD1 shows how aggregate demand has grown.

An increase in aggregate demand means a rise both in real gross domestic product (real GDP) and in employment levels.

AS-AD model

Figure 2: Expansionary Monetary policy

Fiscal Policies

Tax Reduction

Governments use taxation to stimulate economic growth and develop new industries.

Business activities are negatively affected by high taxes as they discourage consumption, and even investment.

The government reduces the tax burden on consumers and businesses when it wants to create more jobs.

Tax cuts lead to higher consumption and increased incomes for consumers.

An increase in demand can lead to higher revenues and more jobs.

Australia’s government took steps to reduce its tax burden.

Australians who have a taxable income over $180 000 have had their tax rates cut by 2% from the 2017-2018 financial period (Power 2017, 2017).

Small businesses were also exempted from corporate taxes, which was reduced from 28.5% down to 27.5% in the 2017-2017 trading periods.

The government also announced in the 2016-2017 budget that it would gradually lower the corporate tax to 30% to 25% (Australian Taxation Office 2016, 2016).

These actions are designed to stimulate economic growth as well as accelerate government’s efforts at reducing unemployment.

Increase in Government Expenditure

The government can also encourage economic expansion and create jobs through various programs.

The government can, for example, fund new public projects like the construction of roads and bridges.

These programs are proven to increase individual disposable incomes, as well as consumption levels, and create employment.

Australia’s government continues to invest in infrastructure improvement as part of its efforts to create more jobs.

The policy actually helped Australia avoid a severe economic recession in the Great Depression of 2009.

Two schemes were implemented by the government during this crisis. They were the Economic Security Strategy Package worth $10 billion and Nation Building and Jobs Plan which was worth $42 Billion (Australian Government 2017).

The shortcoming of fiscal and expansionary monetary policies

Expansionary policies can be ineffective, particularly if the targeted population fails to respond.

Low confidence may mean that cutting taxes won’t increase consumer spending. Other people might prefer to save money than spend.

Lowering interest rates can also be harmful if banks don’t lend as much or consumers aren’t willing to borrow (Sloman Wride & Garcia, 2015).

Expanding monetary and fiscal policy may prove counterproductive when the economy is at full capacity.

This is because a higher amount of money can lead to demand-pull inflation, which could be harmful for the economy.

Low-interest rates could lead to overborrowing and a speculative boom where commodities’ prices increase excessively quickly (Hubbard & O’Brien (2013)).

High borrowing is required by governments to finance expansionary fiscal instruments.

Heavy borrowing is not possible for countries with large amounts of debt or high bond yields.

In the long term, expanding policies can lead to a crowding out of effect.

This will result in the deprivation of funds by the private sector for investments, which can lead to a decrease in economic growth.

Conclusion

In order to reduce unemployment, the governments typically use fiscal and monetary expansionary policies.

These policies include a reduction of interest rates, purchase of government bonds and security, tax cuts, and increased government expenditure.

These policies could lead to inflation, and sometimes they fail to work when there’s low confidence among producers and consumers.

References

Australian Government.

Part 2: Nation Building, Jobs Plan: Building prosperity and supporting jobs today.

Australian Taxation Office.

The reduction of the corporate tax rate.

Principles of economics.

Power, T. (2017. July 3rd).

Reduced income tax for 2017/2018 year and 2016/2017 year

RESERVE BANCK OF AUSTRALIA.

Operations in Financial Markets

Scutt D. (2017 Feb 6th).

Why Australian interest rates will not return to levels pre GFC.

Economics (9th Edition).

Harlow: Pearson.

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