Discuss how the government and the central bank should respond to an economic slowdown and a recession


23 Mar 2015

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At the end of year 2008, economists suggested that the economy may be led to -or already in- a recession when economic growth was decelerating. The official definition of a recession is two successive quarters with a decline in gross domestic product (GDP). However, the National Bureau of Economic Research (NBER) identifies that a recession as a “significant decline in economic activity spread across the economy, lasting more than a few months” based on a number of economic indicators, with an emphasis on trends in employment and income. It doesn't confine itself to use the technical definition of two quarters of negative GDP growth because it is only assessed quarterly and it is subject to revisions. By the time GDP growth is negative for two quarters, the recession is already well happening. However, an economic downturn is defined less strict. For instance, we were in an economic downturn even with positive growth because the economic growth rate was slowing down, house prices were falling, unemployment rates were increasing and people could see the business cycle that moved from a boom period to bust. To respond to an economic slowdown and recession, government and central bank should take active roles in resolving economic issues through the use of two expansionary policies: fiscal policy and monetary policy.

While the economy is not officially in a recession, there are signs that economic activity is slowing. According to CRS Report for Congress, 2008, economic growth in the United States was negative in the fourth quarter of 2007 after two strong quarters, but turned positive in the first and second quarters of 2008. According to one data series (graphs), employment fell in every month of 2008. The unemployment rate, which rose slightly during the last half of 2007, declined in January and February of 2008, but began rising in March and by August stood at 6.1%. The continuing financial turmoil is also cause for concern. Forecasters, while projecting slower growth in 2008, remain uncertain about the likelihood of a recession. If financial market confidence is not restored and private market spreads remain elevated, the broader economy could slow due to difficulties in financing consumer durables, business investment, college education, and other big ticket items.

When the economy is down turning, economist believe the central bank should place more emphasis on short-term monetary policy as it takes fewer time to implement and its decisions to significantly decrease interest rates, and natural market adjustment, along with the already enacted stimulus, would be enough to avoid recession. When there is a massive intervention in the financial markets, the transmission of money can be stimulated into the financial sector and ultimately into the broader economy, where an important expansion of credit could significantly raise aggregate demand. It is said to emphasise more on monetary policy than fiscal policy because there are lags before a policy change affects spending. Therefore, stimulus could be delivered after the economy has already entered a recession or a recession has already ended. First, there is a legislative process lag that applies to all policy proposals — a stimulus package cannot take effect until bills are passed by the House and Senate, both chambers can reconcile differences between their bills, and the President signs the bill. Many bills get delayed at some step in this process. As seen in Table 8, many past stimulus bills have not become law until a recession was already underway or finished.

Is additional fiscal stimulus needed during the economy slowdown? It depends on the current state of the economy. Fiscal policy temporarily stimulates the economy through an increase in the budget deficit. Fiscal stimulus can take the form of higher government spending (direct spending or transfer payments) or tax reductions, but normally it can boost spending only through a larger budget deficit. A deficit-financed increase in government spending directly boosts spending by borrowing to finance higher government spending or transfer payments to households. A deficit-financed tax cut indirectly boosts spending if the recipient uses the tax cut to increase his spending. Economists usually agree that spending proposals are somewhat more stimulative than tax cuts since part of a tax cut will be saved by the recipients. The most important determinant of the effect on the economy is its size.

Economic performance can be illustrated through shifting in aggregate demand and aggregate supply curves. Aggregate supply and demand are shown in the graph below. If consumer confidence in the economy falls and people reduce their spending, aggregate demand will fall, reducing real output and prices and possibly dropping the country into a recession (figure1).

As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. As fiscal policy is the use of government spending and taxes to stabilize the economy, Keynes recommends that parliament should increase government spending in order to “prime the pump” of the economy during periods of recession. At the same time, he calls for tax decreases in recessionary times, to increase consumers' disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand brought about by such actions leads firms to increase production, hire workers, and increase household incomes to enable them to buy more. While both tools are effective, Keynes advocated change in government spending as the more effective fiscal policy tool, because any change in government spending has a direct effect on aggregate demand. However, if taxes are reduced, consumers most likely will not spend all of their increase in disposable income; they are likely to save some of it. Referring to the graph, a rise in government spending G or a decline in autonomous taxes will cause the aggregate demand AD shift to the right, thus increasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*.

When economy is running into recession, central bank is one of the agencies responsible to influence the demand, supply and hence, price of money and credit in order to keep production, prices, and employment stable. To do this, the central bank uses three tools: open market operations, the discount rate and reserve requirements. In order to bring the economy out of recession, central bank will lower the reserve requirements. Due to the act, member banks are required to keep less money, and so more money can be put into circulation through expanding their loans to firms and people. Furthermore, with the use of its open market operations for buying government securities, the central bank pays for these securities by crediting the reserve accounts of its member banks involved with the sale. With more money in these reserve accounts, banks have more money to lend, interest rates may fall, and consumer and business spending may increase, encouraging economic expansion. The discount rate is serves as an indicator to private bankers of the intentions of the central bank to enlarge the money supply. So a lowered discount rate which is announced by the central bank encourages more banks to borrow from the reserve banks. According to the graph below, a central bank open market purchase of securities, a fall in the discount rate or a decrease in the required reserve ratio will raise the money supply, thereby increasing aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level, P*.


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