The Effect Of Government Intervention To The Economy

Published Date: 02 Nov 2017

The University of Hong Kong

Department of Real Estate and Construction

RECO1014

Land Economics

Tutorial Paper :

Income determination, fluctuation, stabilization and growth

K.L. Shea and E.Shea

Name : Chan Chun Yin

UID : 3035046285

Submission Date : 25/4/2013

Introduction

All over the world, many countries’ governments carry our policies which intervene their economy. These actions can be found easily when there is an economic slump, such as the financial crisis happened in 2008, which causes a lot of countries to take action in order to stabilize their economy. The economy seems get stabilized now, but is it the effect brought about by the government policies? The Hong Kong government believes in the self-regulating mechanism of the market. However, even if the government policies is not focusing on the market, there may still have some effect towards the economy. In this essay, personal opinions are given to the main idea of the tutorial paper.

Gross Domestic Product (GDP)

Gross domestic product (GDP) is an economic indicator which is widely used in all over the world to measure the total market value of final goods and services an economy produces in a year. GDP is measured in money terms as it is the most convenient way to compare the values of the goods and services. It includes final goods and services only because if intermediate goods are counted, the value will be overestimated. GDP considers the place of production only regardless of the nationality of the producers. As GDP is measured by dollar terms, if there is inflation in an economy, GDP will also increase although the output can be the same or even lower. Therefore, if we are focusing on the amount of output only, we should use the same price level to compare the values.

GDP can be measured in three different ways. The first one is value-added approach which sums up all the value difference in each production and consumption stage. The second one is income approach which sums up all the factor income received by the parties involved in the production and consumption. The third one is expenditure approach which only sums up the value of the final goods and services produced and ignores all the intermediate process.

Although all the three methods give the same amount of GDP, the expenditure approach is more common and is adopted by the Hong Kong government. It is because it requires less complicated calculation and the value of final goods and services are more easily accessible than the intermediate goods and services. The Census and Statistics Department is responsible in collecting and saving the data. They act as important reference for the government to understand the economic performance of the city so as to find out the most suitable policies to improve the economy. For example, from the data of exports and imports, the government can see whether international trade is in a balanced position.

The GDP of Hong Kong can be divided into several major components. The following equation shows the simplified version of derivation of GDP :

GDP = C + G + I + X – M + IS

C : Private consumption

G : Government spending

I : Gross investment

X : Total exports

M : Total imports

IS : Increase in stocks

On the other hand, if we are considering the whole nation instead of an independent locality, another economic indicator is used, which is named gross national product (GNP). GNP is the sum of GDP and the citizen’s factor income from abroad minus the factor income accruing to foreigners. However, it is not used as common as GDP due to the fact that it is hard to find out the income earned by local citizens in oversea countries as they do not have to pay tax to their local government.

Income Determination

Income determination can be studied on two competing theories, which are the classical school and the Keynesian school.

The classical school states that income is completely determined by resource endowment. Full employment always exists in the economy as the market mechanism pushes excess demand or supply to their balanced level. The output of the economy can be found by the following production function :

Q = F(K,L)

Q : Output Level K : Capital L : Labour

The Keynesian school states that resources may not be fully employed and so income is not totally determined by resource endowment. An upper limit is set and if the demand is lower than it, unemployment occurs. On the other hand, if the demand is higher than it, full employment as well as inflation occurs. The income of the economy can be found by the following function :

Y= [(a – b) + I + G + X] / [1 – (c – m) (1 – t)]

Y : Income a, b, c : Constant

Income Fluctuation

Income fluctuates all the time and the main source of it is demand and supply of the economy.

Keynesian school use multiplier accelerator to explain income fluctuation. Income is increased by investment through the multiplier. The consequence is that more investment will be induced as there is change in income through the accelerator. The process continues and the whole income path will be produced. It can be shown by the following equation :

Yt = a + (c+b)Yt-1 – bYt-2 where t is the period

Stabilization Policy

Three different theories are suggested to explain income fluctuation from the supply side.

The first theory states that workers can be cheated by unexpected inflation and the supply of them will increase as they make think that the real wages are high. The result is output increases faster than the natural rate. However, it can only be applied in short run as workers will eventually find out they perceive the wages wrongly.

The second theory states that not only the workers perceive wrongly on the wages under unanticipated inflation, the firms do so as well. Imperfect information causes the firms to increase the price of their products and the output will then increase. The consequence is that both the employment and the output will increase faster than the natural rate.

The third theory does not mention imperfect information. It states that in different time periods, labour will have different working attitude. If real wages are likely to increase, like at the time of technology advancement, workers will work harder, and vice versa. Therefore, under unanticipated inflation, output will increase.

According to the above three theories, income fluctuate and whether the government should carry out policies to stabilize the economy is the main concern. The two economic models hold contrasting views on this issue.

The classical school thinks that the government should not intervene the market. It is because exact information of the market can be obtained after a lag. Workers and firms will restore the output to the normal level when the real information is available. Also, the time needed and the actual effect of the policy is not predictable. It may have adverse effect to the economy.

On the other hand, the Keynesian thinks that the government should intervene the market. It is because full employment can be attained and it is the desired economy. Both fiscal and monetary policies can be applied. Fiscal policy refers to the control of taxation and government spending. For instance, under inflation, the government should increase tax rate and reduce government spending and the reverse action should be done under unemployment. Monetary policy refers to the manipulation of money supply. For example, under inflation, money supply should be decreased to discourage investment and the reverse action should be done under unemployment.

Economic Growth

The neoclassical model states that the output of an economy depends on the amount of capital and labour available. If capital or labour increases, output increases. While the Keynesian model states that investment generates production capacity and demand through the multiplier. Although the two models give competing theories, they have a common feature, which is the fact that savings act as a source of capital accumulation. The amount of investment savings affects the growth pattern of the economy. The more the economy saves, the higher the growth rate. Saving can be considered as postpone consumption since it will eventually be used in investment.

Limitation of Government Policy

The effect of government policy can be estimated by investigation and research, but it is only estimation and the actual effect can never be predicted. If there is some wrong analysis on the issue, the policy may pose serious problems to the economy. The government cannot stabilize the economy, but further fluctuate it.

Moreover, the time needed for the policy to be effective is unknown. It may have immediate effect but usually it takes more than a year for the economy to react to it. With same period of time, the economy may be self-regulated without the need of applying any government policy. If the effect is seen only few years after implementation of policy, new economic problem may occur before the effect comes out. Then the government can never stabilize the economy even if it tries to deal with all the problems.

In addition, the policy may not be enforced due to political or social reasons. For example, if the proposed policy can stabilize the economy only if one party, say the property developers, is willing to face considerable loss of their business, the policy must be rejected by the party who has to suffer.

CFPEcon101. (2010/11/29). Keynesian Economics Is Wrong: Economic Growth Causes Consumer Spending, Not the Other Way Around.

Retrieved from http://www.youtube.com/watch?v=D9kfMx8Llcc

If the government tries to increase government and consumption expenditure by borrowing money from private capital market, it seems that the income of the economy is increased. However, actually there is a drop in investment expenditure. The overall result is a reallocation of components of GDP without a actual economic growth. In order to deal with this situation, we should find out the gross domestic income (GDI) as well. GDI measures how national income is earned while GDP measures how national income is allocated. Pro-growth policies such as lower tax rate, reducing the burden of government spending should be done to facilitate proper economic growth.

Impact of Government Policy

If the government tries to expand an economy by adopting policies, there will only have a short term effect. In the long run, real growth will not exist or even result in negative growth. It is because economic growth is brought about by unmanaged activities where people are free to find out others' needs but not by the intervention from the government. The invention of iPhone is an example of it. It perfectly matches the taste of the customers at that time. It cannot be anticipated by the government and is done by trial-and-error in the production process. Government can only control resources to help in increase of production of output.

For example, if the government increases taxation under inflation, the amount of capital that investors own will decrease as they have to pay more tax, they will then have less resources and interest to do business investment. Also, if the government tries to spend more government expenditure to raise the level of production, interest rate will increase due to increased output as well as increased demand for goods. The increase of interest rate lower the incentive of investment as the cost for borrowing money is increased. Although the government spending is increased, private investment is decreased. In the end, the rate of economy growth will be lowered or remain unchanged.

Moreover, government intervention in the market will cause a change in price of goods and services. The demand and supply of the product will subsequently change and become imbalanced. Price is a reference for the producer to find out the availability of their product and for the consumer to find out the need of the product. It destroys the benefit of a free market transaction that producers can supply something which suits the demand of consumers.

Conclusion

Actually, the government has its crucial role in the stabilization of the market. It should be a facilitator of growth instead of a generator. Some critical measures should still be done by the government. For instance, the government should maintain public order and enforce commercial contracts. If the government does not carry out extra policy to intervene the market, the economy can be stabilized by itself due to the market demand and supply.

K.L. Shea, E. Shea. (1996). Income determination, fluctuation, stabilization and growth.

Steve Forbes, Elizabeth Ames. (2009). How Capitalism Will Save Us: Why Free People and Free Markets Are the Best Answer in Today's Economy. NY:Crown Publishing Group