Monetary and fiscal policy are government attempts to smooth the business cycle,

Question

Monetary and fiscal policy are government attempts to smooth the business cycle, especially the use of expansionary policies to return to GDP growth from a recession. The goals are relatively short-term, not more than 5 years. Long-term growth, however, is arguably more important.

A) If natural resources are ultimately finite, does this imply that there is a limit to per capita GDP? Explain.

B) The great economist Joseph Schumpeter coined the term “creative destruction” to characterize the free market economy. Why should governments facilitate competitive markets and free international trade if competition is inherently destructive?

Explanation / Answer

Answer A:

Business cycles constitute regular cyclical pattern of economic boom (expansions) as well as bust (recessions). Government is in the position to stage booms and busts through monetary and fiscal policy. Monetary policies are the changes made in interest rates overnight by the Federal Reserve. In order to increase economic activities, Government reduces interest rate and vice versa. Fiscal policy are the changes made to the federal budget deficit. Economic activity increases with increased budget deficit and vice versa. In all, policy changes made to smoothen business activities affect the economy only temporarily since booms and busts are transient.

Expansionary policy is done by lowering interest rates by increasing the money supply available in the economy to entice businesses into expanding. By increasing the amount of money in the economy, the central bank promotes private consumption. This process also promotes lending and investment. Thus, increase in consumption and investment leads to a higher aggregate demand.

Due to above reasons, short-term policies are preferred more by policymakers than long-term growth.

Sometimes, business owners believe that Government is planning long-term policies and hence, they anticipate higher future prices for their services. Business owners adjust their long-term plans accordingly by taking out loan for expanding their businesses. Again, it becomes a vicious circle when economy fails due to heavy loans and inability to pay back.

Hence, long-term growth is the more important of the two since it is the key to raising GDP of the country. Policy changes in the areas of education, taxation, research and development, infrastructure and technological progress brings in long-term growth rate.

It is always important for Government to target long-term growth. This will have lasting effect on per capita GDP unlike short-lived increased per capita GDP caused by expansionary policies. It is important for policymakers to set a limit upon expansionary policies undertaken for short-lived growth in per capita GDP of the country.

Answer B:

Creative destruction is a business term wherein, the original products are brought to end in order to come with new line of production. The process of creative destruction is an essential fact about capitalism. Some countries may not be that develop to inherent advanced technology. They do not have the resources enough to adopt newer technology. They have use worn-out technologies from the developed countries untill their own resources are developed. For example: Certain underdeveloped countries may have to rely on age-old cabled internet connections as they do not have enough resources to adopt wi-fi technology.

This gap in technology serves as good capital incoming for developed countries. This technological gap is mostly found in ammunition technology.Due to these reasons, government facilitates competitive markets and free international trade even if competition is inherently destructive.

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