Tuesday, May 29, 2007

Can Governments deal with Economic Shocks?

Discuss The Extent to Which Government's can deal with the Problems caused by economic shocks.

Demand side shocks are events that adversely affect AD. For example, a fall in the stock market can cause a drop in confidence, consumer spending and economic growth e.g. 1929. In response to this, the government can implement expansionary fiscal or monetary policy. Lower rates of income tax, increase personal disposable income, and therefore, encourage consumer spending. This can kick-start the economy. However, fiscal policy may be subject to some problems. If confidence is very low then lower income tax may be insufficient to increase AD. It will also cause a bigger budget deficit.

Higher government spending may lead to crowding out. This suggests that higher government spending doesn't increase AD. This is because government spends more by borrowing from the private sector; therefore, the private sector has less to spend. Monetarists argue this makes fiscal policy ineffective. Keynesians however, disagree; they argue the government is using resources not currently utilised. Therefore, higher government spending leads to increased AD; there may also be a multiplier effect.

Supply Side Shock are events that affect Aggregate Supply. For example, an increase in the price of oil causes AS to shift to the left. Therefore, this causes lower growth and higher inflation. Therefore, it is difficult to solve both problems at the same time. For example, higher interest rates may reduce the inflation, but it will make the fall in growth worse; it could lead to a recession.
See also: Cost Push Inflation

An alternative to demand management is to use supply side policies. These are policies that can increase productivity and shift AS to the right. For example, privatisation, may cause increased efficiency. However, supply side policies can take a long time to have an effect.

It also depends on whether the shocks are global or not.

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