Advantages of the Fed increasing interest rates when the GDP gap is positive
Increasing interest rates helps to prevent inflation. When the GDP gap is positive, it means that the rates of inflation are likely to go up in the near future (Baumol, 1998). This is because the increase in disposable income suddenly causes an increase in demand for goods and services. As a result, demand exceeds supply such that prices go up causing inflation. Increasing interest rates reduces money supply so that demand falls back to the equilibrium level. Demand is equated to supply again such that the high prices witnessed during inflation are reduced.
Increasing interest rates helps in stabilizing money wages. Producers may react to increase in demand through increasing production which may necessitate the increase in number of workers or the number of hours worked by existing employees (Baumol, 1998). This sudden demand for labor puts an upward pressure on money wage causing an imbalance. By increasing interest rates, producers’ ability to obtain credit decreases so that expansion is controlled. Disadvantages of the Fed increasing interest rates when it believes the GDP gap is positive
Increase in interest rates could have the effect of discouraging investment. The Fed could increase interest rates in the hope of reducing demand but this could also have a negative effect (Baumol, 1998). Increase in interest rates causes the rise in the cost of credit such that investors are not in a position to obtain capital. This could lead to a slowdown in the economy. If interest rates are raised for long, this could eventually lead to a recession (Baumol, 1998). High interest rates mean that money supply is reduced such that customer purchasing power is reduced.
This means that businesses are not getting enough profits and may end up closing down to avoid losses. The result of this is unemployment due to layoffs and increase of number of people relying on transfer payments. Types of countercyclical fiscal policy Automatic Stabilizers These represent programs that are set to correct the imbalance in the market without any need for policy action by the government. They adjust automatically during recession and during boom thereby preventing business cycle upswings or downswings (Baumol, 1998).
Examples of programs include corporate profits, disposable income, income taxes and transfer payments. During a boom, the aggregate corporate profits increase. This expansion will cause an increase in taxes due to the progressive nature of tax. As more income is taken up by tax, aggregate income reduces thus expansion is limited. Similarly, transfer payments such as unemployment compensation decrease when disposable income increases. This means that the government gives out less money and thus money supply is contained.
On the other hand, a reduction in recession causes reduction in income and more people demand transfer payments so that the government has to spend more. Decrease in income decreases amount of taxes due such that disposable income is limited and consequently contraction is automatically contained. Discretionary fiscal policy In the use of discretionary policy, the government deliberately manipulates its expenditure, taxation and transfer payments so as to correct economic imbalance (Baumol, 1998).
During boom, the government could increase taxes and reduce government expenditure such that the supply of money is reduced. This way, demand goes down so that prices which have otherwise risen as a result of inflation go down. During recession, the opposite happens such that the government increases its expenditure and reduces taxes. This way, disposable income in increased and increased money supply leads to a rise in demand. Consequently, prices go back to equilibrium as the excess supply is eliminated. Reference Baumol, W. J. (1998). Principles and policies. Boston, MA: Houghton Mifflin HarcourtSample Essay of Paperial.com