Question

You have just been appointed to a special Presidential Task Force on Economic Growth. You are responsible for proposing three policies that the government can enact to increase the growth rate. What policies would you recommend and why?

Answer 1

Policies to improve economic growth are focused,  

1. to increase aggregate demand (Demand-side)
2. to increase aggregate supply (Supply-side)

We will focus on current global scenario of decline in demand [i.e. demand side policies]

Fiscal Policy : The government can boost demand by cutting tax and increasing government spending.

• Lower income tax will increase disposable income and encourage consumer spending.
• Higher government spending will create jobs and provide an economic stimulus.

The problem with expansionary fiscal policy is that it leads to an increase in government borrowing. Meanwhile to finance this extra spending, the government have to borrow from the private sector. If the economy is already growing, then higher government borrowing can crowd out the private sector. However, if the economy sees a rapid fall in private spending, and a rise in the saving ratio, expansionary fiscal policy can help provide a boost to demand in the economy without causing crowding out. Similarly, during a period of economic expansion, the government may need to do the opposite of higher taxes and lower spending to create a budget surplus.

Monetary policy : Monetary policy is the most common tool for influencing economic activity. To boost AD, the Central Bank (or government) can cut interest rates. Lower interest rates reduce the cost of borrowing, encouraging investment and consumer spending. Lower interest rates also reduce the incentive to save, making spending more attractive instead. Lower interest rates will also reduce mortgage interest payments, increasing disposable income for consumers. The central bank can also reduce the reverse repo rate so that the banks are disincentivised to park there money with central bank and eventually banks are required to provide more loans.

Quantitative easing : Quantitative easing (in a liquidity trap) involves increasing the money supply and buying bonds to keep bond rates low. The increase in the money supply and lower interest rates will boost investment and economic activity. But increasing the money supply could cause inflation. Though empirical studies suggests that the inflationary impact is minimal. Without quantitative easing, the recession is likely to expand, though it is not enough to return the economy back to a normal growth projection.

[ Supply side policies include : Privatisation, deregulation, tax cuts, free trade agreements ]