Government Role in Managing Short run Instability in the Economy

Question: Write an report onGovernment should play active role in managing short run instability in the economy caused by unemployment and inflation problems. Answer: In the long run, we all are dead said John Maynard Keynes. The basic assumption behind the same was the fact that it is the short run stability in the economy achieved through fiscal tools (i.e. taxation and government spending) that matters rather than thinking about the long term effects of such measures. According to several economists including Keynes, in the long term every parameter/indicator (namely labour and capital) changes because of the changes in technology, the scientific temper and the desire to make the world a better place to live in. Further, the economy of any country is lead by its people or households, who are dynamic in nature with each one behaving in a different manner to the same problem in front of them. The economy is a product of all decisions undertaken by each household. Thus, it becomes really difficult to understand the exact impact of the measure. In the current context, it is short term stability (reducing unemployment and inflation) which the government looks to achieve through the use of fiscal policy. In a country like India, where the government has the power to control instability (long run or short run), the correct use of fiscal tool can go a long way in achieving short term stability. Thus, leading to the economic growth of the countrys in long run. Just as a proverb goes A rupee saved in a day can provide you saving of 365 rupees in a year. In the same manner, achieving short term stability can go a long way in achieving long run stability in the economy. In short run, households prefer to have economic stability with continuous employment and stable incomes. This allows them to undertake major investment decisions in the future by foregoing the current consumption. In one word, people understand and appreciate the opportunity cost of foregone consumption for a better living in the future. In short, if we maintain strong and stable macroeconomic fundamentals, it can go a long way to contribute towards economic growth and welfare. The logic for the above arguments is simple. Economic stability over a period of time increases the confidence of its people in its governments actions and policies. This in turn leads to increase in savings of the people due to stable income over a period of time. Once the savings increases, it gets invested by the households or by the banks for generating economic activity. With the generation of economic activity, there is increase in production of goods and increase in employment. This increase in employment provides people with wages, which are in turn spent on purchase of goods and services. Thus the economic cycle keeps moving, finally leading to economic growth and welfare. In this smooth running economic cycle, there creeps in the problem of economic instability. The problem of economic instability arises because of multiple factors affecting the demand and supply of goods in the economy. According to the classical economists, the instability in the economy arises due to the dynamic behaviour of each household towards its consumption and investment decisions. These individual decisions combined for an economy produce a collective demand and supply of goods and services, which is unstable in nature. For Example, person A and person B draw salary of 30,000 per month but person A chooses to save the amount for future consumption but person B chooses to spend the same for buying a motorcycle. Person A salary does not contribute to the economic cycle at present but person B salary helps the cycle to move. In short, every person acts according to their own needs and circumstances, which might not contribute to the economic cycle as mentioned above. This is t he sole reason for economic instability arising in the economy. The Classical Economists where the one who thought that economic instability is a regular phenomenon and should be left upon the natural forces to correct them. But we all are aware of the Great Depression of 1930s and the government seemed to be helpless. It was during this time that the economist realised that they had missed out on the basic fundamental of the economy. This was the time when the concept of macroeconomics came to light bringing along with it new theories and possibilities. In the later years, Keynes introduced us to the concept of Business Cycles. The Business cycle of boom, constant, recession and depression where thought of to be a natural phenomena, something that can be predicted. To everyones dismay the economic crisis seems to surpass all predictions. The US subprime lending crisis and the very recent Euro Crisis stand as testimony to the statements mentioned above. There is a general consensus among all economists including Keynes that a mild instability in the economy caused primarily due to inflation (not more than 5% on year-on-year basis) is good and depicts the healthy state of the economy. But Keynes on the other end advocated on the use of appropriate tools of macroeconomic policy to cure the instability in the economy. Every economy has a monetary and fiscal policy to control the macroeconomic instability in short run or long run. We have seen that the monetary policies where ineffective to lift the economy out of depression in 1930 and during the post World War II. Thus, Keynes along with several other economists was of the view that fiscal policy shall be used for correcting the economic instability. In India, the fiscal policy of the government mainly consists of taxation and public spending as tools for controlling any instability in the economy. The economic instability is mainly caused due to two factors: unemployment and inflation. The second term i.e. inflation or price instability is something the government seems more concerned because inflation leads to increase in prices of goods and services. Once there is rise in price, the real value of money decreases. The household in the economy turn bearish and stop buying the goods and services. This leads to reduction in production of goods which affects the economic growth of the country. Inflation can be reduced by controlling the growth of aggregate demand or giving a boost to the growth of aggregate supply. In other words, for bringing the economy from the state of instability to stability we need to control aggregate demand or aggregate supply component through proper fiscal policies. It can either choose to use the tool of contractionary fiscal policy or expansionary fiscal policy. Fiscal policies generally work through changes in the aggregate demand for goods and services as the effect is fast and effective. A fiscal expansion (increase in government spending through tax cut or increase public spending) leads to an increase in the aggregate demand for goods and services. An increased spending by the government leads to increase in disposable income for households (increased transfer payments or increased casual employment), thus leading to purchase of goods and services increasing aggregate demand. In a similar manner, if there has been a tax cut, the same shal l lead to increase in disposable income in the hands of the salaried individuals, thus increasing the spending or consumption, leading to an increase in aggregate demand. The importance of fiscal policy in bringing stability to the economy has also been recognised because of its ability to affect the amount of total output produced i.e. Gross Domestic Product (GDP). Contrary to the discussion made above, that fiscal policies affect the aggregate demand component and now we say that they affect the supply side of the economy. A closer look at the way in which the fiscal policy works would actually help us understand that fiscal policy affects the aggregate output and the prices of goods and services by actually affecting the aggregate demand. This happens because fiscal policies change the aggregate demand leading to changes in the aggregate supply, thus helping the economy in maintaining demand supply equilibrium. Further, it all depends upon the state of economy when the fiscal measures are taken by the government. If the economy is in the state of recession (i.e. there is continuous fall in the GDP of the economy over a period of time), fiscal expansion measure shall be undertaken by the government. A fiscal expansion measure shall provide people with employment opportunity and thus provide them with wages. The same shall be spent on purchasing of goods and services. This shall bring in money in the hands of entrepreneur and prompt him to kick start the production of goods and services due to the demand generated for the goods and services. Thus, there shall be an increase in the overall output of the economy or increase in GDP of the economy. If the economy is in the state of full employment level (i.e. all the people in the economy are employed and earning), this leads to the problem of excess supply of goods and services. The excess supply of goods leads to reduction in its price and thus a fall in investment. At this point of time, the fiscal policy will have more effect on prices and less impact on total output. A contractionary fiscal policy method shall be adopted which increase the amount of taxes on wages and services. This increase in taxes shall actually reduce the amount of disposable income in the hands of the people. Thus, there will be less spending on goods leading to reduction in aggregate demand for the commodity and thus reducing the aggregate supply as well. Fiscal responsibility is an important part of the government aim of seeing its economy grows over a period of time. Fiscal responsibility can only be achieved with judicious use of the fiscal tools available with the government. The same was realised by the US government when they had plunged into the subprime lending crisis. The main reason for the crisis was people obtaining loans from banks and locking their money in the real estate market. The real estate market was flourishing and people were hopeful of large gains leading to loan settlement. The banks also responded positively to the whole market scenario. Unfortunately, the real estate sector started becoming stagnant with people no longer interested in buying houses at such exorbitant prices. Within days, the real market sector stopped flourishing and in a matter of few weeks, people who had borrowed money from banks, declared themselves unable to repay the loans due to continuous loss. Several banks closed down due to the pr oblem of large NPA (Non-Performing Assets) accumulation and there was rampant unemployment. The situation turned such worse that government had to use its expansionary fiscal policy, in the form of providing bailout package to the banks for sustaining them during the crisis period. This gives us a clear example of the effectiveness of fiscal tools as an important measure to contain economic instability. A stable environment plays an important role in bringing economic growth. In order to achieve the stability, we need to understand the market forces, their mechanism and the factors hey react to. This makes the role of policymakers and the economists very critical. Their main work revolves around understanding the instability before it occurred and undertaking preventive measure to maintain stability. With the stability of the external and internal forces, brings back the confidence of people in their economic system, to invest their surplus in the market. With investments, the economic cycle starts moving leading to growth and welfare. Overall, the ability of fiscal policy to improve employment during recession and reduce the price levels during boom, leads to balanced economy in the short run. The automatic stabilizer tendency of the fiscal policy certainly makes it an effective tool for the government to manage short term instability in the economy. This means that the role of the government becomes essential as the proper use of the fiscal policies shall lead to stable economic growth of the economy. 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