Money and Prices in the Long Run and Open Economies
This essay covers an overview of the U.S. economy and how economies in general function. This economic outlook entails: comparisons of historic and future predictions of U.S. economic indicators, an explanation of how the government can affect the wellness of the economy, an analysis of how monetary policy could influence inflation rates in the long term, a description of how trade shapes the productivity and the gross domestic product, a discussion on the significance of two vital markets in the economy, and finally a recommendation on what the government can do to help grow the economy.
Comparing Histories and Forecasts of U.S. Economic Indicators
Let’s begin with the changes in gross domestic product (GDP) in the United States over the past years. According to Trading Economics, an online economic database, GDP has been growing in our country every year for 9 straight years. Only from 2008-09 was there a decrease in GDP. The forecast predicts that in the next 5 years it will continue to grow to over 23 trillion dollars (Trading Economics). Both our past and predicted future GDP measures appear to steadily grow.
How Government Policies Can Influence Economic Growth
Diving further into the overview of an economy and how it operates we begin to see a regulating entity that manages an economy. The government plays this position and has a vital role in the economy of a society. Its function, in regards to the economy of that society, is to support the goals of economic growth, low unemployment, and low inflation. Governments can reach these goals by exercising two methods: monetary policy and fiscal policy (Exploring Business, 2010). For reference in today’s world the United States economy will be focused on as an example to display how these means are practiced.
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Monetary policies are enactments by the government that utilize its regulating authority to adjust the supply of money and the level of interest rates (Exploring Business, 2010). In the United States, the Federal Reserve System (Fed), the central bank of the country, is in charge of this responsibility. In fact, there is a specific sect within the Fed that works out monetary policy called the Federal Open Market Committee (FOMC). The FOMC affects the supply of money in the economy through what is known in the economic world as open market operations. After meeting with its members and discussing what direction the supply of money needs to be moved in conducts these open market operations by purchasing or selling U.S. government bonds. If the FOMC decides to increase the money supply it will produce dollars that will be used to purchase the bonds. This results in more money in the hands of the public which equals an increased supply of money. If the Fed wanted to decrease the money supply they would sell the bonds to the public which causes a reduced supply of money as the public exchanges their dollars to government. Both of these actions ultimately affect interest rates simply because as banks have less and less money it becomes more and more difficult to loan it out which ends in higher interest rates. Conversely, the same holds true, because as the banks have more and more loanable funds it becomes easier and produces lower interest rates (Mankiw, Ch. 16, 2015). Monetary policy indirectly changes the money supply through a series of causes and effects, but the government also has a more direct method.
Fiscal policy is the other tool used by the Fed to affect the money supply. When the government reduces spending and when it increases taxes, the result is a decreased money supply. The opposite is true as well, when the government increases spending and when it decreases taxes, the consequence is an increased money supply (Exploring Business, 2010). Like monetary policy, fiscal policy is a tool used by the Fed that causes a cascade of causes and effects that ultimately influences the intended result.
How Monetary Policy Could Affect the Long Run Behavior of Inflation Rates
Monetary policy also has long term implications on the rate of inflation. To explain this we will begin with the quantity theory of money. This is a theory that asserts that growth in the money supply governs the rate of inflation. Following this school of thought, monetary policy that increases in the supply of money would increase the inflation rate. The most notable example of this phenomenon found in real world history occurred in Zimbabwe. Zimbabwe once printed their own currency that was similar in price to the U.S. dollar. The government decided to enact monetary policy that increased the supply of money by printing more dollars and pumping them into the economy. Prices eventually increased again afterwards so the central bank elected to increase the inflation rate more. This began a cycle of increasing the inflation rate to solve the short term problem, but a larger long term problem was growing. As more money was entering the economy with each monetary policy action the value of each dollar was decreasing. As each dollar gradually lost value more dollars were required to pay for goods and services that were once worth less dollars. Instead of printing more single dollar notes the central bank began printing higher note amounts. This then lead to the lower note amounts becoming less and less valuable and therefore less used in the economy because they had a minute amount of purchasing power. This cycle continued on in Zimbabwe until the central bank stopped printing their own currency and switched to other currencies. Once the dust had settled on their vicious cycle of increasing money supply that kept leading to increases in inflation rates, the central bank had printed notes worth 10 trillion in the Zimbabwe dollars. Those notes at the time were worth around 3 dollars in America. This example demonstrates how monetary policy can affect not only the short run, but also the long run of inflation rates (Mankiw, Ch. 17, 2015).
How Trade Deficits or Surpluses Can Influence the Growth of Productivity and GDP
Trade between countries affects an economy in a significant way as well. Trading between economies involves exports and imports. Exports are goods and services produced within a country and sold abroad while imports are foreign goods and services that are purchased domestically. When the values of each are combined the imports are subtracted from the exports to form what is referred to as net exports or the trade balance. Because exports add money to an economy it increases the net exports and because imports reduce the money supply of an economy it decreases the net exports. When an economy has more total exports than total imports there is a positive amount in net exports which is called a trade surplus. In contrast, when an economy has more imports than exports they have a negative amount in net exports which is termed a trade deficit. When both are equal and the net exports is zero, a country is labeled as having a balanced trade (Mankiw, Ch. 18, 2015).
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Trading internationally also influences a country’s GDP or output. GDP provides a measure of the value of all final goods and services produced in a country. Final is the key word in the definition that implies the goods or services have not been double counted which would overestimate the result. A high GDP displays that a country’s economy has a high output and would be considered a larger economy (Kurtzleben, 2014). GDP is calculated using a formula that has four components all added together: consumption, investment, government purchases, and net exports (Mankiw, Ch. 10, 2015). Because net exports are a pivotal element in the calculation of GDP, trade deficits and surpluses can be very impactful to the output of an economy.
Trade between economies also shapes the productivity of a country. Mankiw defines the economic term of productivity by testifying that it is “the quantity of goods and services produced from each unit of labor input” (Mankiw, Ch.1, 2015). If a country exhausts a minor amount of resources to produce a major amount of goods or services, then that country would be considered highly productive. Inversely, if a country depletes a sizeable amount of resources to produce a scarce amount of goods or services, then that country would be considered less productive. According to an article in the International Monetary Fund Blog, trade boosts productivity by exposing domestic firms to a higher level of competition through importing, by learning from foreign customers through exports, and by reallocating resources between domestic companies toward a more productive apportionment (Ahn and Duval, 2017). Knowing this we can more clearly envision how trade deficits or surpluses can alter the productivity of a nation.
The Importance of the Market for Loanable Funds and the Market for Foreign Currency Exchange to Our Economic Growth
The markets for loanable funds and foreign currency exchange hold imperative functions in the growth of our economy as well. The market for loanable funds causes our economy to shift for a few reasons that will be expounded, but we will begin by defining what the market for loanable funds is. Mankiw expresses to his readers this market consists of a supply of loanable funds that is derived from national saving and that the demand of loanable funds emanates from domestic investments and also the net capital outflow (NCO) (Mankiw, Ch. 19, 2015). Net capital outflow being previously delineated by Mankiw as “the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners” and characterized as always being equal to net exports (Mankiw, Ch.18, 2015). Knowing this we see that the market for loanable funds is where the demand of loanable funds, those who are seeking domestic investments, meets the supply of loanable funds, those who are saving their money in the economy (Mankiw, Ch. 19, 2015). The point at which these two lines intersect is where the real interest rate, which basically is the cost of borrowing money in our economy after the effects of inflation are excluded (Mankiw, Ch. 11, 2015). This figure is keynote component in the importance of our economic growth because it sets the NCO, which is equal to our net exports, in a positive or a negative position. When the real interest rate is higher there is a negative NCO, also known as a net capital inflow, and when it is lower there is a positive NCO. After the real interest rate modifies the NCO, the NCO then moves the supply of foreign currency which directly affects the market for foreign currency exchange. The reason the NCO directly shifts the supply in this market is because once foreign currency is invested domestically, in cannot be used domestically and therefore must be used abroad. Once the supply has been set by the NCO, it meets the demand curve to set the equilibrium real exchange rate. The demand for foreign currency is set by the cumulative exports of the country. When foreign currency grows weaker, the total exports of the country increases because they can purchase more for the money they have and when it grows stronger, the net exports decreases as domestic dollars no longer go as far as they previously did (Mankiw, Ch. 19, 2015).
Taking a step back to see how these markets come together is paramount. In our economy these two markets are of chief importance. The amount of saving in depository institutions of the American people sets the supply of loanable funds. This supply meets the amount of domestic investment and NCO we currently have to adjust the real interest rate. Afterwards, the real interest rate establishes the NCO, which then regulates where the supply of foreign currency in the foreign currency exchange market. Where the supply is determines where demand meets it and at that spot the real exchange rate is set (Mankiw, Ch. 19, 2015). The implications of ignoring these two markets will be conveyed to further present their magnitude. Imagine the American people were not saving money. The supply for loanable funds would dwindle leaving only reserves in the banks which would mean that there could be not investing domestically. As the supply for loanable funds would begin to plummet, the demand would start skyrocketing. This would cause a drastic increase in the real interest rate which would cause a huge net capital inflow, or negative NCO. The supply of foreign currency would follow in dramatic fashion decreasing which would ultimately cause the real exchange rate to skyrocket as the American dollar weakens in the global market.
A Research Driven Recommendation of What the Government Should Do to Encourage Economic Growth
My recommendation of a plan of action for the government to encourage economic growth is to drastically reduce, or even eliminate completely, tariffs that are impeding the benefits from international trade. Currently, we are in the midst of a “trade war” with China that is leading to losses of productivity and economic growth opportunity on both sides. According to Business Insider’s Bob Bryan, these tariffs could increase costs of parts and materials which causes the American people to have to foot the bill through higher prices (Bryan, 2018). This is simply not good for our economy and needs to be reversed.
So in all, this economic outlook has covered the history and forecasts of economic indicators, conversed on how government policy can grow or weaken the economy, analyzed how monetary policy can influence inflation rates in the long run, reviewed how trade adjusts the growth of productivity and GDP, taught on how pivotal the market for loanable funds and the market for foreign exchange currency are to the economy, and finally provided a recommendation on what our president can do to help the economy grow.
- Ahn, J., & Duval, R. (2017, May). How trade with China boosts productivy. IMF Blog . Retrieved from https://blogs.imf.org/2017/05/24/how-trade-with-china-boosts-productivity/
- Bryan, B. (2018). Trump’s trade war could cost every middle-class American family $453 and could eliminate 292,000 US jobs. Retrieved from https://www.businessinsider.com/trump-trade-war-china-steel-tariffs-could-cost-us-families-jobs-2018-12
- Government’s role in managing the economy. (n.d.). University of Minnesota Libraries, (), . Retrieved from https://open.lib.umn.edu/exploringbusiness/chapter/1-7-governments-role-in-managing-the-economy-2/
- Kurtzleben, D. (2014, June). What does GDP measure/. Vox, (), . Retrieved from https://www.vox.com/2014/6/20/17587364/what-does-gdp-measure
- Mankiw, N. G. (2015). Principles of macroeconomics (7th ed.). Retrieved from https://phoenix.vitalsource.com/#/books/9781305727625/cfi/6/50!/4/2@0:94.7.
- Trading Economics. (n.d.). United States Gdp. Retrieved from https://tradingeconomics.com/united-states/gdp