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Discuss Effect of Expansionary Demand-side Policies on Balance of

EFFECT OF EXPANSIONARY DEMAND-SIDE POLICIES 7

DiscussEffect of Expansionary Demand-side Policies on Balance of Paymentsand Environment

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Manycountries have policies in place to strengthen their innovation ineconomic performance. These policies are wide-ranging and most aim atshaping demand for innovative good and services. Although the mix ofpolicies differs considerably between countries, due to institutionaland structural difference, in the recent past, which has seen a shiftin the mix of policies in order to support business innovation. However, there has been a growing attention on expansionarydemand-side policies. This is because of the greater awareness of theimportance of feedback linkages in the innovation between processbetween demand and supply. According to OECD (2011) demand-sidepolicies aim at addressing other perceived market failures, namelyproblems related to diffusion of innovation and market introduction.The main forms of expansionary demand-side policies includeexpansionary fiscal, monetary and trade policies. This paper will evaluate and analyze the impacts of these demand policies on theenvironment and on the balance of payment.

Effecton the balance of payment

Theimpacts of monetary and fiscal policies on the balance of paymentsare quite similar except for the effects on interest rates. Anexpansionary monetary policy brings down interest rates because ofthe increase of the money supply (Tragakes, 2011). The policy leadsto a lower interest rate that stimulates investment demand and henceraises national income and price level both of which would worsen thecurrent account. The resulting balance of payment deficit is likelyto cause a parallel loss of foreign exchange reserves, which thecountry may not be able to afford. Central banks are oftenconstrained from pursuing an expansionary domestic monetary policybecause of the fear that foreign exchange reserves might be exhaustedby such payments deficits, particularly if reserves were low at theoutset.

Theexpansionary fiscal policy pushes up interest rate because of theincrease in expenditure and income, which increases the demand formoney. This is likely to crowd out private investment, weakening theexpansionary effect of increased government spending. Pryor (2002)points out that, in a fixed rate regime with constant money supply,the expansionary fiscal policy influences the balance of payments intwo common offsetting ways. This policy tends to raise the interestrate, an outcome that would attract foreign funds from abroad and,thus, gives rise to a deficit in the balance of payments. Inaddition, with high mobility international capital markets,expansionary fiscal policy may cause Central Bank to intervene in theforeign exchange market by lowering the value of domestic currency.This intervention raises the nation’s monetary base and moneysupply, which reinforces the effects of the policy. Conversely,greater domestic power would give rise to increased imports, which inturn increases a deficit in the balance of payments.

Expansionarymonetary policy in the context of a fixed exchange rate isineffective because an expansionary monetary policy creates a balanceof payments deficit. This deficit automatically decreases the moneysupply, offsetting and eventually eliminating the original increasein the money supply. This deficit may also imply that the supply ofdollars on the supply of dollars on the foreign exchange marketexceeds the demand. As a result, those without the capability toobtain foreign exchange for their dollars go to the government toexchange at a fixed rate. This decreases the money supply, as thegovernment sells foreign currency to them at a fixed rate and obtainsdomestic dollars, which normally would be removed from publiccirculation. The main point here is during this process thegovernment is selling off its holdings of foreign exchange. In thecase where there is a balance of payments deficit that continues topersist, the government’s stock of foreign exchange continues tosteadily fall.

Expansionarymonetary policies, especially Central Bank lending to the governmentin an open economy, expands the monetary base and leads to balance ofpayments deficits through reduction of the foreign assets in CentralBank. The resulting effect may be particularly severe because moneycreation by the central bank does not reduce resources of the privatesector. The effect on the balance of payments is less than the impactof deficit financing by the central bank. Furthermore, borrowing fromthe non-bank public by the government results in a direct transfer ofresources to the government and reduces the external leakage by thenon-bank public.

Onthe other hand, expansionary fiscal policy leads to an increase inaggregate demand affecting the balance of payments (Gamber andColander, 2006) . This means that firms and domestic consumers willhave more income and so will increase their spending on imports.Hence, the current account position will deteriorate. Furthermore,tighter fiscal policy will reduce domestic demand and hence thedemand for imports is likely to fall. For example, when the domesticdemand falls as a result of the tighter expansionary fiscal policy,the domestic firms may increase their efforts to find markets fortheir goods by looking overseas. Similarly, a fall in aggregatedemand due to tighter expansionary fiscal policy should moderate therate of inflation.

Environmentalimpacts

Thegovernment can use fiscal policy to influence the economy. This maycall for changes in government expenditure and taxes to achieveeconomic goals, which may include lowering the level of unemployment,price stability and economic growth. To begin with, an increase ingovernment expenditure, or a fall in government taxes, lower budgetsurplus and higher budget deficit, which increases in aggregatedemand. In turn, this leads to increased price level, which alsoincreases inflation. On the other hand, there is a higher level ofoutput that lowers the level of unemployment. This is because asmaller change in government taxation and spending reduces theimpacts of aggregate demand and the labor market. Thus, it ispossible the expansionary fiscal policy can lead to high output andbring about a fall in unemployment without any increase in inflation.

Thedetails of an expansionary fiscal policy action are enormouslyimportant to the firm’s microeconomic environment. The policyaction is known to increase expenditure resulting to differentmicroeconomic effects than increases spending. This is obvious thatexcessively expansionary fiscal policy may itself be the source ofthe capital flow. Coupled with tight monetary policy, this could leadto high real interest rates that initially provide an environmentthat attracts and encourages capital inflows. It is also possiblethat capital flow can also be influenced by the domesticinstitutional environment, especially the extent to which it supportsproductive and profitable investments. Expansionary fiscal policy isconsidered supportive to the domestic institutions due to the factthat fiscal policies have relatively low and stable tax rates and theprovision of corporate tax incentives for foreign investments, aswell as, establishment of free trade zone (Arnold, 2013).

Expansionaryfiscal policy is likely to affect the long-term economic growth rate.This results from economic growth, which is caused by supply factorssuch as technology, investment and education among others. For thisreason, the policy can increase the GDP in the short term. It ispossible that the increased aggregate demand leads to higher output.Many economists emphasize that the expansionary fiscal policy is anappropriate policy to use during the times when the economy is inrecession below full employment. The application of the policy wouldthen return the economy to operating at full capacity on itsproduction frontier.

Lastly,expansionary monetary policy can increase the total amount of moneyin the economy. Fernando (2011) urges that expansionary monetarypolicy is traditionally used to combat unemployment during recessionby lowering interest rates. Fernando also adds that, in a broaderperspective, monetary policy deals with controlling financialinstitutions, control availability of money, and maintenance ofstability of the country’s currency, as well as, the securityprices.

Inconclusion, the expansionary demand-side policies, fiscal andmonetary policies, are two important tools of a country’smacroeconomic policy. However, the two are complementary policieswith one common objective, which is to attain full employment, butthe method of each is different. The monetary and fiscal policies arealso instruments available in different arms of the government, andare formulated and implemented by the same government but differentdepartment, Central Bank and the treasury respectively. However, itcan be concluded that expansionary monetary policy is lessunsuccessful, especially in a closed economy, while fiscal policy canbe more successful in stimulating the economy.

References

Arnold,Roger A.. Economics.Cincinnati, Ohio: Cengage Learning, 2013. Print.

Colander,David C., and Edward Gamber. Macroeconomics.Upper Saddle River, N.J.: Prentice Hall, 2006. Print.

Fernando,A. C.. BusinessEnvironment.Chennai: Pearson, 2011. Print.

Nolan,Alistair. Businessinnovation policies selected country comparisons..OECD Publishing: OECD, 2011. Print.

Pryor,Frederic L.. Thefuture of U.S. capitalism.Cambridge, UK: Cambridge University Press, 2002. Print.

Tragakes,Ellie. Economicsfor the IB Diploma With CD-ROM.Cambridge: Cambridge University Press, 2011. Print.