Money and the Prices in the Long-Run and Open Economies

Abstract

While the American economic outlook is not robust, it is fairly healthy for a country that was in a major recession less than a decade ago. For years, the economy has had an annual growth rate of less than 2% and is likely to continue this trend. Surprisingly, the unemployment level is natural in spite of irrational exuberances creating busts and booms. One of the major changes is observable in American oil industry, where new fracking technology allow production of a domestic oil hence minimizing over-reliance of Middle Eastern oil. The move also symbolizes US contracting external influence and its preparation to shift to a consumer-driven economy rather than an import-export model.

Money and the Prices in the Long-Run and Open Economies

The world’s most dominant economy operates at two speeds. First, a lackluster global demand and a strong American dollar weigh on export despite the mounting business investment pressure due to political uncertainties and low oil prices. Secondly, an upbeat consumer confidence, skyrocketing real wages, and unyielding labor market boost household spending. Late in summer 2016, ISM manufacturing contracted due to a decrease in nominal retail sales. It is attributable to the falling gasoline prices instead of slowing consumption of goods and services. Interestingly, the consumer fundamentals are buoyant since the business sector creates more than 200, 000 jobs per month (Bernanke, 2016).

Despite multiple domestic challenges and transforming global economic landscape, the United States plays a pivotal role due to its large diversified economy. The US GDP represents more than 20% of the total global output, surpassing China’s by more than five trillion dollars. However, the United States is quickly falling behind other small countries such as Singapore and Norway in GDP (PPP). Yet, it boasts a technologically advanced and highly developed services sector accounting for approximately 80% annual outputs. Start-up firms dominate US economy, especially in areas such as technology, and healthcare. Besides, large US firms play a leading role on a global stage as multinationals.

Although the service sector is a fundamental economic engine, the manufacturing sector accounts for 15% of the total output, only second to China. Even as the America’s global influence fades, it is still a powerhouse due to classy physical infrastructure and access to plentiful natural resources. There is also a productive and well-educated labor force, hence a full leverage of human capital in a free-market environment. The US economy has flourished over the years because of a functional legal system, political stability, and an effective regulatory structure. The new immigrants introduce an entrepreneurial culture and solid work ethic, thus providing high-quality jobs to the local population. For decades, capital investment, innovation, research, and development drive America’s economic growth.

Notably, the country is emerging from a tumultuous economic phase. A major recession in 2008 began due to factors like lax state regulation, excessive risk taking by money lenders, and high consumer indebtedness. Other factors include widespread mortgage lending, low-interest rates, and property boom. The contraction of US economy continued between 2008 and 2010 but started picking up a year later after the government spent 1.6 trillion on a stimulus plan. Mainly, these finances resurrect troubled firms for financial system stability.

Additionally, the government introduced expansionary monetary policies to support the weak and vulnerable economy. The move entails sustaining the low-interest rates and acquisition of financial assets to minimize long-term interest rates. In addition, the government prints more money for quantitative easing. Consequently, the unemployment level is gradually returning to the pre-crisis levels as the labor market recovers. Regardless, economists are skeptical on the health of the economy, given persistent stock market shocks and the exit of manufacturers to the emerging economies such as China (Jorgenson & Stiroh 2012). Other signs of the sluggish economy include wage stagnation, high medical and pension costs, infrastructure deterioration, rising income inequality and large budget deficits. Over the next five years, economists project that US economy will worsen unless the government focus on domestic matters rather than increasing military spending and pivoting to Asia.

            Government spending should drastically reduce in five years. Since the 2008 depression, it has grown faster and unhealthily. Even worse, most of the expenditures are to other causes rather than national defense or homeland security. The Obama administration should understand that the looming baby-boom generation retirement will lead to higher entitlement costs. Hence it needs to make early preparations by cutting on unnecessary overseas expenditures.  It is recommendable for the United States to adopt a small-government fiscal policy to avoid being less competitive.

            Budgetary control should serve as a chance for economic virtue out of monetary necessity. Excessive government spending for a prolonged period has a negative economic effect. Exceptionally, productive government spending may yield a high rate of return and economic benefit. However, in case the rate of return is relatively slower than the private sector’s the economic growth slows down. Reducing the government’s burden within the next 5 years leads to a faster economic growth since its current spending is very high.

Trade Deficit is not a crucial variable. The main factor is the government’s size and out it finances its operations. While it is true deficits and high taxes are harmful, siphoning money from the private sector and spending them in counterproductive policies neutralizes the chances of rebounding from the economic slump. If the national government had a surplus, it still would consider reducing spending.

Regulating federal expenditures is necessary due to globalization. Today, it is increasingly easy for jobs to migrate from developed economies to the growing nations like China and India. Therefore, the enactment of substantial policies rewards considerably.

The Effect of Monetary Policy

In the short-run, monetary policy affects inflation and demand for services or goods. In addition, an introduction of monetary policy leads to high demand for a skilled workforce to produce commodities. When the economy was fairly performing in the United States, the Federal Reserve adjusted federal funds rate to influence performance in the financial market. The changes affect short-term loans which in turn influence the long-term residential mortgage rates and corporate bond rates. Shifts such as these in those seen in the long run interest rates affect the future asset prices, dollar value, and equity prices.

            Over time, the changing financial conditions impact the economic activity. For instance, when long-term interest rates drop, people can borrow cheaply. Therefore, the citizens are more willing to expand business operations and acquire properties. In response, business entities increase spending by boosting production and hiring more laborers. Eventually, the increasing household wealth triggers additional spending. The links between employment, production, and monetary policy are undetectable, making it hard to gauge monetary policy’s long-term economic effect.

Furthermore, monetary policy sways inflation rate. For example, when the government reduces federal funds, the high demand for services and good pushes wages and other expenditures higher to reflect increased demand for materials and labor. They contribute to the production process. Besides, policy actions affect the people’s expectations on the future economic performance, and these speculations directly influence the current rate of inflation.

In the year 2009, when the long-term interest rates reached zero (hence could not fall further), the Federal Reserve invoked emergency monetary policy measures for economic support. For instance, between early 2009 and late 2014, the Federal Reserve acquired notes and long-term mortgage securities to increase the amount of money in circulation. The move also lowers the long-term interest rates. Since the 1990s, the US current account

Balance of Payments

Over the past three decades, the international trade flows have influenced the America’s current account balance. Earnings on investments and American assets overseas constitute an insignificant part of the current account. In addition, the surplus category cannot offset sizeable trade deficit. If there is a current account deficit, the value of services and goods sold to foreign buyers are more than those purchased from abroad. Since late1990s, America’s current account deficit expanded rapidly before peaking at 6% of GDP in the year 2007. It then dropped sharply in the following years and leveled at 2.3%. The drop is due to an increasing oil production in the USA.

Capital account surplus mirror the current account. In fact, financing the current account is possible due to capital inflows from abroad. Foreign firms (mostly Chinese) continue to invest in US firms and their assets, thus earning US the top spot in FDI rankings. In 2012 alone, US received $167 billion in FDI where 40% was from the manufacturing sector. 

America is one if the leading exporter and importer of services and goods globally. Nevertheless, the country has a trade deficit because it depends on oil from the Middle East to meet the domestic energy demand. In the year 2013, the trade deficit reached 701 billion. America plays a critical role in the global trade platform because it endorses free trade agreements while minimizing trade barriers. Among them are TPP and NAFTA (North American Free Trade Agreement).

The US government is struggling to eliminate adverse effects of recession through a combination of monetary and fiscal policies. The government actively implements a stimulus program and minimizes tax rates to stabilize the economy. In addition, the Federal Reserve utilizes both unconventional and traditional policies to tackle economic shocks. The US has a reputation as a successful enforcer of free-market policies. However, excessive government intervention has narrowed the differences between a Capitalistic economy and China’s communism.

Loanable funds and Foreign Exchange

The net capital outflows involve investments, savings, and foreign exchange. In a market for loanable funds (or investments), people deposit their savings in the banks. On the other hand, businessmen wanting to expand their investment borrow loans from financial institutions. Therefore, all income corresponds to savings in both government and private accounts (Ize & Yeyati, 2013). On one side of the equation, there are savings, while on the other side, there is foreign and national investment constituting loanable funds. Hence, there is equilibrium when net capital outflows and equal investment savings. High-interest rates imply relatively high ROI for loaners. Conversely, people borrowing loans return more due to additional interests.

When the US government experiences budget deficit, it remarkably cuts the amount of loanable funds, given that the expenses are more than annual revenues. Therefore, the negative value for government savings minimizes the total savings. At the same time, the real interest rate rises as the net capital outflow drop. In turn, the amount of dollars supplied for foreign exchange decreases. In the end, there is an appreciation of real exchange rate.

The net export rise since at any real exchange rate, import quota remarkably diminishes imports. Consequently, foreigners have to acquire more dollars for buying US net exports. While this raises the real exchange rate, there is no observable change for loanable funds market. Hence, the effect on real interest rate is negligible.

In summary, the strategic plan is achievable despite slow US economic growth. First, the US government is reputed for implementing effective interventions to salvage the economy in times of crisis. For example, the Federal Reserve introduced monetary and fiscal policies to halt economic contraction within two years. Therefore, businessmen and consumers have confidence in future American economic prospects. Secondly, US’s is a global leader in innovation and research and development. Besides, there is a skilled workforce to ensure business success and expansion. Third, most countries use US dollar as a reserve currency hence can maintain its value despite government’s economic stimulation program. However, the government has to focus on domestic spending, especially in the infrastructural upgrade.

References

Bernanke, B. S. (2016). US Economic Outlook. Vital Speeches of the Day, 73(9), 377.

Ize, A., & Yeyati, E. L. (2013). Financial Dollarization. Journal of International Economics, 59(2), 323-347.

Jorgenson, D. W., & Stiroh, K. J. (2012). Raising the Speed Limit: US Economic Growth in the Information Age. Brookings Papers on Economic Activity, 2012(1), 125-210.