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Managing the Economy. Economical Effects of Reduced Government Spending

Hausarbeit 2012 19 Seiten

BWL - Sonstiges

Leseprobe

Table of Contents

List of Figures

1. Introduction

2. Decrease of Government Expenditure by ten per cent
2.1. National Income
2.2. Economic Growth
2.3. Unemployment
2.4. Inflation
2.5. Government Borrowing and Debt
2.6. Exchange Rate

3. Additional Policies
3.1. National Income
3.2. Economic Growth
3.3. Unemployment
3.4. Inflation
3.5. Government Borrowing and Government Debt
3.6. Exchange Rate

4. Conclusion

Bibliography

List of Figures

Figure 1: Impact on National Income (changes in G)

Figure 2: Impact on Economic Growth (changes in G)

Figure 3: IS Curve (changes in G)

Figure 4: Impact on the Rate of Unemployment (changes in G)

Figure 5: Phillips Curve

Figure 6: Impact on the Inflation Rate (changes in G)

Figure 7: Impact on Government Borrowing* and Government Debt** (changes in G)

Figure 8: Impact on the Exchange Rate (changes in G)

Figure 9: IS*- LM* Model

Figure 10: Impact on National Income (changes in G and T)

Figure 11: Impact on Economic Growth (changes in G and T)

Figure 12: IS Curve (changes in G and T)

Figure 13: Impact on the Rate of Unemployment (changes in G and T)

Figure 14: Impact on the Inflation Rate (changes in G and T)

Figure 15: LM Curve (reduction in money supply)

Figure 16: Impact on Government Borrowing* and Government Debt** (changes in GT)

Figure 17: Impact on the Exchange Rate (changes in G and T)

1. Introduction

The following analysis is based on computer simulations provided by Biz/ed’s virtual economy, an online model based on the one used by HM Treasury. The virtual economy enables experiments with economic policies and demonstrates impacts on several macro- and microeconomic factors (Biz/ed, 2011).

In 2010, the British government announced the goal to reduce government spending for areas other than health and overseas aid by an average of nineteen per cent over four years thereby aiming to reduce Britain’s deficit and provoking sustained economic growth. To investigate the impacts of such a policy, the virtual economy model will be applied to demonstrate effects on the economy when government spending is reduced by ten per cent.

2. Decrease of Government Expenditure by ten per cent

2.1. National Income

National income is defined as “the total income earned by a nation’s residents in the production of goods and services” (Mankiw and Taylor, 2011). As Figure 1 shows, national income decreases initially after reducing government spending compared to levels without the changes but will be higher than otherwise in the long run. As national income is dependent on a number of components, these will be covered in more depths in the following.

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Figure 1: Impact on National Income (changes in G)

UK Gross Domestic Product, in real terms (i.e. after adjusting for inflation, 1995 prices) in millions of £s (Biz/ed, 2011)

2.2. Economic Growth

Figure 2 shows that a cut in government expenditure results in a significant initial decrease of economic growth, going down to 1.13 per cent in 2003, compared to levels without the changes, where growth would increase to 2.79 per cent (Biz/ed, 2011).

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Figure 2: Impact on Economic Growth (changes in G)

Annual rate of growth in Gross Domestic Product in per cent (Biz/ed, 2011)

Due to the cuts in government spending companies reduce their production leading to lower output and thus income (Y). As economic growth describes “secular increases in the output of an economy” (Burda and Wyplosz, 2009, p.523), lower output is responsible for the observed incline in growth. This outcome responds to what the IS-LM model suggests. Figure 3 illustrates that reduced government spending shifts the IS curve, which describes the relationship between interest rate and level of output in the goods and services market (Mankiw, 2007, p.558), to the left, because of the lower output it implicates.

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Figure 3: IS Curve (changes in G)

Adapted from Burda and Wyplosz, 2009, p.253

Figure 3 additionally shows that lower output also results in lower interest rates. In the medium to long-term lower interest rates make it more lucrative to borrow money having a positive effect on investments and therefore stimulating the economy. This explains why the long-term economic growth is greater as is the case without changes (Figure 2).

2.3. Unemployment

Changes in economic growth are closely related to changes in unemployment rates, which is explained by Okun’s Law, who states that growth in output is negatively related to the change in unemployment levels (Gärtner, 2009, p.530). Therefore, a slightly shifted rise in unemployment (Figure 4) is not surprising when considering that Y initially decreases after cuts in government spending, as such a development results in a lower demand for labour.

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Figure 4: Impact on the Rate of Unemployment (changes in G)

UK Unemployment, using the "claimant count" measure, as a percentage of the total labour force (Biz/ed, 2011)

When unemployment is at its peak in 2006, economic growth is already rising, reaching higher levels as would be the case without the changes. Unemployment levels are in turn lower than they would be without the spending cuts, when economic growth is already slowing down again.

2.4. Inflation

The relationship between unemployment and inflation is explained by the Phillips Curve (Figure 5), which “postulates a negative relationship between inflation and unemployment” (Gomes, 2011). Therefore, the higher the inflation rate in an economy, the lower unemployment (Figure 4).

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Figure 5: Phillips Curve

Adapted from Bade and Parkin, 2011, p.378

When adapting the Phillips curve to the given example, the numbers show that the inflation rate is lowest in 2006 (Figure 6), suggesting a deflation of 0.81 per cent at a time when unemployment is at its highest level and in turn reaching its peak of 2.91 per cent in 2009, when unemployment is at its lowest level (Biz/ed, 2011).

illustration not visible in this excerpt

Figure 6: Impact on the Inflation Rate (changes in G)

Inflation (% average annual increase) in the RPI, minus mortgage interest payments (Biz/ed, 2011)

2.5. Government Borrowing and Debt

As government debt is the sum of overall government borrowing (Abel, Bernanke and Croushore, 2011, p.586), both graphs in figure 7 illustrate that the budget deficit decreases in the long run compared to levels without the changes. Initially, an increase of government borrowing and debt is observed, which can be explained by the fact that fiscal policy has a multiplied effect on income and output (Mankiw and Taylor, 2011, p.319). When considering the consumption function it becomes evident that a lower income leads to lower consumption (C), which in turn results in lower tax (T) revenues (Burda and Wyplosz, 2009, p.235).

Due to the multiplier effect, decrease in tax incomes can be greater than the reduction of expenditures and thus lead to a greater budget deficit, as is the case in the short run after government spending is reduced (Figure 7).

illustration not visible in this excerpt

Figure 7: Impact on Government Borrowing* and Government Debt** (changes in G)

*The Public Sector Net Cash Requirement (formerly the Public Sector Borrowing Requirement) as a percentage of GDP (a government budget surplus would be shown negative)

**Total Government Debt as a percentage of GDP (Biz/ed, 2011)

2.6. Exchange Rate

When examining the impact of reduced government spending on the exchange rate it has to be considered that the following graph (Figure 8) needs to be seen upside down as the virtual economy model is based on the US economy (Raeva-Beri, 2012). Therefore, it can be observed that the policy changes result in a lower exchange rate (Figure 8).

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Details

Seiten
19
Jahr
2012
ISBN (eBook)
9783656852209
ISBN (Buch)
9783656852216
Dateigröße
755 KB
Sprache
Englisch
Katalognummer
v284887
Institution / Hochschule
Ashcroft International Business School Cambridge – Anglia Ruskin University
Note
1,3
Schlagworte
managing economy economical effects reduced government spending

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Titel: Managing the Economy. Economical Effects of Reduced Government Spending