Introduction
Recession is said to be an economic issue, that is characterized by general increase in prices of goods and services that is inflation, and at the same time in the economy there is higher levels of unemployment. Over the last few months ago, what has been observed in the world economy is steep increase in prices of oil that has triggered an increase in the prices of other commodities. This has been followed by a drying up of cash from the lending financial institutions. On reaction to this, what the financial institutions have done is to cut down their lending. For this reason, investors are finding it hard to acquire cash for investing. Consequently, this has lead to increase in the level of unemployment due to reduced levels of unemployment.
This has really made the financial institutions to struggle to raise their cash. Actually, what is happening in the economy is increase in debts and high demand for cash by the households. This has been referred inelegantly to be “deleveraging” which simply means bludgeoning for demand. Now, the big responsibility for the central banks and the governments is to stop the deleveraging before in gains strength which may lead to destruction of economies. Does the government have alternatives from the existing convention macroeconomic policy to curb this problem? Some of these conventional macroeconomic policies include: lowering taxes, cutting interest rates, and increasing the public expenditure (James, 2008).
Theory review and analysis
To respond to the shocks of the demand, it is advisable to the government to apply the monetary policy. This entails reduction of the rates of interest and increase of the supply of money. The reduced interest rates will stimulate more spending by consumers and investors, as there is little saving due to fewer returns from savings. In this case the central bank is plays a vital role, as it is the one that controls the monetary base. At lower interest rates the cost of holding money by consumers and investors is low, implying that there will be more money in circulation and therefore more spending. This means that investors are spending much of there cash on investment projects and therefore opening more opportunities for employment. Another area where we can increase the money supply is by having the bank reserves reduced. This will mean that most of money deposits in banks are to be reduced and the rest lend out. Therefore the bank reserves in this case matter a lot as they act as the foundation for the broader money kinds. However, the big challenge for policy at the moment is the financial crisis that the financial institutions are facing (James, 2008).
The banks thus here act as the conduit between the wider economy and the policies of the central bank. What now has turn to be the big problem to implement some of the central bank policies is current financial crisis. This has blocked the conduit. The reduction of rates of interest by the Federal Reserve has shown no much difference than there before. The banks credit cost for American households and the firms have not gone down by much. What is happening to investors is that they are wary of lending to banks as they are likely to run out of cash. The banks are even unwilling to lend to each other. The two issues are arising because the spread between the central bank cash payment and what is paid by them to borrow for three months is above the levels of pre-crisis (James, 2008).
One of the options by the central banks to tackle the issue of blockage is to have a direct lending to the firms through purchase of their short term debt at rates that are fixed. But one of the challenging problems with this policy is that it tends to turn central banks into commercial banks putting taxpayers to lending risk. Despite low interest rates, in big economies the monetary base has swollen as a result of more central banks liquidity. The increases have been accounted by bank reserves which have been doubling. This case has been witnessed in euro area.
There has been a lot of fear on the expanding monetary base as this may cause inflation. If the money multiplier remains constant, such fear will be warranted. But since the banks are using liquidity from central bank to cater for their short term funding, the money multiplier will collapse regardless of expanding reserve. If cash is stashed in reserves and is not circulating it can not push up inflation or boost spending. If this fear leads to households, banks, and firms to hold cash rather than spending or lending it, the downturn will be worse off. The more the prices fall and weakening of the confidence, the more there is rush for money. This leads the government to opt to use the fiscal policy. The government will have to cut down taxes and increases its spending. This is referred to as expansionary fiscal policy (James, 2008).
During booms and busts in rich countries, the government budget can be used to stabilize the economy automatically. During the periods of slow economy and high unemployment the governments are subject to spending more on unemployment benefits. This on return increases the aggregate demand therefore increasing investment levels thus creating employment opportunities. Though reduction in taxes reduces the government revenue during recessions, it reduces the pains of the firms and employees
The use of fiscal policy, that is taxes, has been outdated thirty years ago. To trigger the aggregate demand the policymakers now opt for the use of interest rates. The proportion of the revenue that has been saved as a result of tax cut may be saved or used to buy imports, therefore lead to a budget deficit. The deficits caused by the two factors may harm the private investors since the government will be forced to raise the interest rates, resulting to crowding out effects. To have this problem solved low yields of bonds could be the market signals to have the public spending crowd in. This can control recession from changing into rout ( James, 2008).
Conclusion
The government should carefully evaluate its nature of the macroeconomic problem before it decides which policy tool to use. This will help to curb the other arising consequences from application of a given policy tool. The use of fiscal policy during recession or any other macroeconomic issue has been found to have some limitations. Big budget deficits may force the government to order printing of more money to settle the debt. This on the other hand may lead to inflation. It also leads to excess tax burden to taxpayers, sale of all public securities to finance the deficit.
However, it has been observed that the conventional macroeconomic policy tools may fail. In this situation, the American government has always opted for the nuclear option. It has been said that to the extreme cases of recession monetising the public debt slug is bound to cause inflation but at this time the inflation can be of benefit where the conventional macroeconomic policy tools are not working.
Reference
James Fryer (2008) Policy in a recession: Putting the air back in Oct 30th 2008. From the Economist print Edition
