Inflation, Monetary Policies, Fiscal Policies, And International Trade Essay.

1. You will need to examine the impacts of demand-pull and cost-push inflation (in the short-run and long-run) using the AD-AS model. You will also need to examine how they interact with each other and outline possible government strategies for managing both types of inflation.

2. You will need to discuss the arguments for and against restricting trade. You will also need to discuss the price and quantity effect of a tariff that is introduced on an imported good that is also produced in Australia. As part of this assessment you will need to discuss deadweight loss.

3. You will need to explain the meaning of an expansionary fiscal policy and its likely impact of on the economy using AD- AS curves. You also need to examine the relationship between the expansionary fiscal policy and the country’s Balance of Payments

Types and impact of inflation

1. Inflation is the persistent rise in general levels of prices leading to a decline in purchasing power. The level of inflation in a country is measured using the retail price index (RPI) which measures change in average price of a unit of goods and services that represent the consumption pattern of a typical household RPI valid (Ball, 2017). Demand-pull inflation occurs when aggregate demand in the economy is more than the aggregate supply. The increasing costs of production pushes price levels higher. Demand-pull inflation occurs when value of aggregate demand exceeds that of output at full employment.

From the graph above, aggregate demand rises from AD1 to AD2 leading to a price increase from P1 to P2. The impact of this type inflation is that, too much money will be chasing few products (Bos, 2014). The increased demand motivates producers to produce more products leading to full employment in the short run and higher economic growth in the long run.

Cost push inflation develops when cost of production in an economy. The increase in cost of production is majorly as result of increased cost of raw materials, and labor costs. The rise in fuel prices in the manufacturing industry is a common cause of cost push inflation (Ehrenberg & Smith, 2016) .From the graph below, businesses increased product prices from P1 to P2 so as to maintain their profits as they were before the risk in the cost of production. The GDP declined from Y1 to Y2 leading to an increase in economic unemployment in the short run and a decline in economic growth in the long run.

Monetary policies are decisions and actions taken by the state through the central bank that ensure consistency of money supply and government growth and pricing objectives. The aim of monetary policies is to maintain stability in prices in the country. There exist several monetary policy measures that the government can implement.  Minimum reserve requirements are the least amount of cash that commercial banks are allowed to operate with (Dar & Amirkhalkhali, 2017).The government can also float government bonds to individuals and corporates through open market operations. The central bank can also engage in Forex transactions to withdraw from or inject liquidity from to the market.

Fiscal policies are inflation control measures where the government adjusts its taxes and expenditure in order to stabilize the currency. Fiscal policies are combined with monetary policies and used to control the country’s economy. Reducing government expenditure lowers the level of inflation by reducing the amount of money in circulation in the economy. Fiscal policies are based on managing demand by ether reducing or raising aggregate demand (Korinek, 2018). This policy is effective only in controlling demand pull inflation.

Monetary policies to control inflation

International trade is the exchange of goods and services across country borders. International trade might be limited by trade restrictions. Restrictive trade is achieved through the imposition of tariffs and quotas on imports (Miller & Benjamin, 2017).Tariffs are taxes imposed on each unit of product imported. It raises prices of imported products such that locally produced goods become cheaper and more affordable for local consumers. Quotas on the other hand limits quantity of a product imported by placing a ceiling in amount of imports. Countries can implement quotas by limiting imports licenses and placing a maximum amount on total imports. Classical economists preferred free trade among countries. However, trade restrictions have now become common in international trade. Recently, the United States of America imposed tariffs on import of steel and furniture from China which China retaliated by imposing tariffs on some American products. The United States levied a 10% import tariff on Chinese products worth $200 billion. The goods include furniture and electrical appliances. In response, China imposed taxes on around 5,207American products of around $60 billion.

Restrictive trade protects infant local producers from foreign dominance. Young local companies with high chance of success once established are protected from competition until they gain strength to compete internationally.  This argument is common in the manufacturing industry majorly in developing nations since they attempt to replace foreign imports with locally produced goods so as to achieve balance of payments.

Restrictive trade reduces export of employment. Importing products from foreign companies reduces employment in the home country. Local industries create employment opportunities for both skilled and unskilled labor. Excessive importing weakens local industries forcing them to downsize their workforce (Ottonello, Presno & Bianchi,2017). In addition, local investors might not invest in the local industry for fear of unfair competition from established foreign countries. The current US-China trade war was motivated by the US intention to protect American jobs. In addition, the American president argued that, the restrictive trade also aimed at reducing unfair transfer of American born technology and intellectual property.

Free trade might lead to dumping of cheap goods whose prices are less than local cost of production. Dumping is commonly perpetrated by foreign monopolies who use high profits at their home country to subsidize prices of exports to gain political and strategic mileage. Importing companies might implement trade restrictions in order to prevent elimination of local industries and prevent dependence on imports.

Fiscal policies to control inflation

Economists and policy makers are divided as to the validity of restrictive trade in today’s economy. Several arguments have been put in place against protectionism by free trade supporters. Free trade allows countries to establish a comparative advantage through specialization. Nations that have natural and human resources to produce a certain product can specialize in producing that product while exporting the surplus to regional and international markets. Specialization allows producers to reduce costs through economies of scale.

Imposition of trade restrictions on imports by one country often leads to retaliation from the other party leading to reversal of benefits of restriction (Copelovitch, 2017). The resultant effect is contraction of volume of trade which is not good for the economy. The long run effect of restriction is reduced output since infant industries seldom grow. The argument against over-reliance on one industry lacks validity in economics.

In presence of a FTA, Australia imports most of its machinery from China since cost of imported machinery is lower than locally produced machinery. When Australia imposes tariffs on Chinese machinery, local producers supply majority of machinery while Chinese machinery imports shrinked. The imposition of the tariff increased price of imported machinery hence favoring local producers.

Deadweight loss is that cost on society associated with market inefficiency. This economic phenomenon result from price ceilings, price floors, and taxation. In international trade, deadweight loss might motivate countries to enter in to free trade agreements especially when local industries do not satisfy local demand in terms of quantity, price, and quality.

3. Fiscal policies are measures used by government in controlling price levels and economic growth in the economy ( Avi-Yonah, & Clausing, 2017). It includes use of expansionary and contractionary policies that have an effect of increasing and reducing money supply respectively. Expansionary fiscal policies are employed during time of deflation in order to increase money supply and foster economic growth and employment.   

Altering amount of government expenditure has an impact of either increasing or reducing inflation levels in the economy. Government is in most instances the greatest spender in every country. Government expenditure affects gross domestic product and thus its increase leads to a direct rise in GDP .The direction and size of its expenses have huge impact on economic growth, and employment rates (McKeehan & Zodrow, 2017). Increased government expenditure acts as an expansionary policy especially during times of deflation.  The government might allocate large amount of capital resources on infrastructure, health, education, agriculture, and manufacturing industry with the aim of increasing money supply in the economy. Increased state expenditure also causes an indirect increase in the level of consumption in the economy.  

International trade and trade restrictions

Taxation is a major fiscal policy used by governments in controlling the levels of inflation. As an expansionary policy, governments reduces taxation. Reduction of taxes reduces recessionary pressures in the economy (Kirschen & Strbac, 2018).It increases disposable income of household’s hence increasing amount of money available for them to spend. Also, when governments reduce taxes increases investor confidence and hence enhancing private investment which increases the GDP. Governments might reduce taxation by reducing rates of taxation or by scrubbing types of originally in force. To attain economic contraction, might either reduce tax or increase expenditure or implement them simultaneously.

The figure above shows a graph of GDP against Prices of a product when government implements expansionary polices. Increased government spending causes the aggregate demand curve to shift from AD to AD2. Reduced taxation also causes also implies that consumers have higher disposable income and hence the AD curve shifts rightwards. The combination of reduced tax and increased expenditure has an effect of shifting the AD curve to the right (Scholl & Schermuly, 2018). The extent of shift caused by tax and expenditure depend on sizes of tax and expenditure multipliers respectively.

References:

Avi-Yonah, R.S. and Clausing, K.A., 2017. Reforming corporate taxation in a global economy: a proposal to adopt formulary apportionment. The Hamilton project.

Ball, R.J., 2017. Inflation and the Theory of Money. Routledge.

Bös, D., 2014. Public enterprise economics: theory and application (Vol. 23). Elsevier.

Copelovitch, M., 2017. This Time Should Have Been Different: The Causes and Consequences of Macroeconomic Policy Failure in the Great Recession.

Dar, A. and Amirkhalkhali, S., 2017. Fiscal Policy, Total Factor Productivity and Economic Growth in Advanced Economies. Applied Econometrics and International Development, 17(2), pp.5-18.

Ehrenberg, R.G. and Smith, R.S., 2016. Modern labor economics: Theory and public policy. Routledge.

Kirschen, D.S. and Strbac, G., 2018. Fundamentals of power system economics. John Wiley & Sons.

Korinek, J., 2018. Trade restrictions on minerals and metals. Mineral Economics, pp.1-15.

McKeehan, M.K. and Zodrow, G.R., 2017. Balancing act: weighing the factors affecting the taxation of capital income in a small open economy. International Tax and Public Finance, 24(1), pp.1-35.

Miller, R.L. and Benjamin, D.K., 2017. Economics of macro issues. Pearson.

Ottonello, P., Presno, I. and Bianchi, J., 2017. Fiscal Policy, Sovereign Risk, and Unemployment. In 2017 Meeting Papers(No. 1382). Society for Economic Dynamics.

Scholl, W. and Schermuly, C.C., 2018. The Impact of Culture on Corruption, Gross Domestic Product, and Human Development. Journal of Business Ethics, pp.1-19.