Policy (45 marks) In many instances, government spending results in the economy
ID: 1106071 • Letter: P
Question
Policy (45 marks) In many instances, government spending results in the economy moving to the long run steady state at the expense of higher inflation levels. All too often, the best policy is simply to do nothing, leaving the market to adjust in order get the economy back to the long run steady state level (full employment) at the lowest price level. The problem with government doing nothing is two fold. First they do not want to be seen as not acting, especially during a recession. Secondly, the economic benefits of the government doing nothing (such as during a recessionary period) takes a long time to materialize (given prices in the economy take time to adjust), which is not popular with governments especially if there is an election. There seems to therefore be a tension between the Bank of Canada who wants to achieve price stability first and output stability second, versus the Department of Finance who is more concerned with output stability and employment creation. Class, please outline the costs and benefits of achieving price stability relative to output stability (In your answer be sure to discuss the fact that there is no trade-off between inflation and unemployment in the long run). Be sure to discuss the costs of inflation, the costs and benefits of reducing it and how this compares to reducing unemployment if at all possible. Can a case be made for targeting zero inflation as the primary objective, especially in the long run? If so, what things can governments do to tackle unemployment, especially structural?
Explanation / Answer
When focus is on price stability ie the Central Bank does inflation targeting, output and therefore growth suffers. When the economy is in the boom and there is scope for more production and employment, price stability in the form of high interest rates can curb the growth and expansion. The biggest cost of price stability is unemployment which ias affecting both the developed and developing countries. This is however in the short run. In the long run, since we assume that expected and actual level of inflation are the same there is no tradeoff between unemployment and inflation.
Costs of inflation are numerous-
1- Instability in the economy- With the cap on prices going free, all the variables like intersts rates, investment, consumption are constantlyaffected leading to lot of inefficiencies.
2- Shoeleather and menu costs- Shoeleather cost literally refers to the cost of going to the bank for depositing money. Ir refers to the opportunity cost of time and effort in holding less money. Menu cost refers to the cost incureed in getting the prices on menus, banners etc changed with rise in prices. The essence is that inflation leads to unnecessary costs.
3- Low confidence on the Central Bank- The people do not consider the government and Central bank credible and may lose trust. This might affect the policy making as then the expectations of people can't be properly reckoned and the people may not react in the way the are expected to prices.
To tackle unemployment there first needs to be high government expenditure. The interest rates should be kept low so that people have an incentive to borrow and put the money into productive uses. Moreover, govt needs to run employmant programmes and reduce uneployment aloowances to motivte people to work.