The multiplier effect describes a situation, when there is an expansion in the money supply, in an economy. The multiplier effect arises, when an initial injection in the economy leads to a bigger final rise in national income. When there is a multiplier effect, the capacity of banking institutions in making loans to individuals and businesses entities increases. The effect is seen as a rational series of occurrences, which can be used in redirecting the economy of a given nation. The multiplier effect is beneficial in allowing the economy respond to present economic situations (Mankiw, 2012). The decision of increasing the money supply in an economy is not a random one, which is made without permitting for any legal regulations or standards, which may apply to the process. Most economies depend on the reserve ratio so as to establish the amount of expansion, which will occur as part of the multiplier effect. This means that maintaining a balance between the amount of deposits, which are made to the bank and the amount of money every bank should hold as reserve helps in deciding the multiplier. As increasing deposits are made, the bank has the ability in providing its customers with vast loan opportunities that aid in stimulating the economy. Establishing the amount of reserve required is a vital element in determining the impact of the multiplier effect. If deemed prudent, nations may opt to use their reserve or national bank systems in increasing the requirement. This implies that a higher percentage of the deposits should be kept in reserve as opposed to using in granting loans. This approach can be applied in an economy to aid in slowing an economy, which depicts signs of accelerating out of control. On the other hand, lowering the requirement has a multiplier effect of aiding in stimulating a sluggish economy through placing more money back in the marketplace and boosting the purchase of commodities and services. When applied cautiously, the multiplier effect can promote the current status of the economy, permitting it to attain the anticipated balance between extremes of inflation and recession.
If a government misconstrue the economic indicators, and create changes to the reserve requirement, which generate outcomes other than those anticipated, the subsequent multiplier effect may bring economic situations that leave consumers in financial conditions that are worse than before. Because of this reason, the responsibility of changing the reserve requirement needs intense scrutiny of the happenings within the economy, estimating what impact shifting the requirement may cause to the various sectors, then establishing additional processes required to occur simultaneously with the alterations so as to generate the most beneficial effect to all concerned. The multiplier effect will work in reverse, when the government cut its spending. Cutting of government spending will lead to a decline in national income. Tax cuts will lead to a multiplier effect since consumers will be encouraged to consume more than before emanating from high incomes (Mankiw, 2012). There is no reason to believe that, during recession period, the multiplier effect is stronger than in close to full employment period. During a recession, the aggregate demand is low, which implies that the multiplier effect is almost negligible. However, during the recession period, the private sector has non productive savings, which limits crowding effect. This implies that there will be a positive multiplier effect during recession.
For quite a time, policy makers and economists have been on the look out on the association between budget deficit and inflation. Policy makers and economists argue that, there is a vast worry of associating inflation with budget deficits. The worries of the association between the two stems from the perspective that, whenever there is a budget deficit, governments are most likely to finance their deficits through borrowing either internally or from foreign institutions. Also, governments may finance their budget deficits through printing money into the economy. In case, the budget deficit spending, is remarkably vast; the spending may have an immense impact on the economy, which may lead to inflation. Economic data for various countries analyzed by policy makers and economists argue that the association of budget deficits with inflation is not direct since the situations under which budget deficits may lead to inflation usually depends; some countries that have high inflation also have vast government budget deficits. This establishes an association between inflation and budget deficits. For developed countries like United States, which has relatively low inflation levels, there is little indication of a link between inflation and budget deficit.
The principal to understanding the association between inflation and budget deficits is the acknowledgment that there deficit spending is associated to the quantity of resources circulating in the economy via the government budget constraint that is the link between spending and resources. At its most primary level, the budget constraint indicates that resources spent have to come from somewhere. For instance, in the case of national and local government, resources may come from taxes or borrowing. On the other hand, the national government may apply monetary policy to aid in financing the deficit. The range over which the monetary policy is utilized in helping balance the budget is paramount in determining the outcome of budget deficits on inflation. Most less developed countries are highly affected by their budget deficits. In most cases, the deficits in the governments tend to cause inflation. As governments seek resources that aid in facilitating the budget deficit, the governments end up hurting the economy. Take, for instance, in a less developing country, the government may seek to facilitate its budget deficit through taxation. Implementation of relatively high tax levels to consumers will have an impact of reducing consumer spending and may also reduce the rate of employment. A decline in the rate of employment will imply that consumers will not be willing to spend more in the economy since they do not have enough or extra resources to spend. A decreased consumer spending emanating from high tax levels will negatively affect the economy. The price tag for various commodities and services will increase due to the expectations of government in raising resources from taxes in facilitating the deficit (Mankiw, 2012). Therefore, in such a scenario, there will be inflation associated with high budget deficits. Also, if the government opts to increase the money supply in order to facilitate the budget deficit; this will also lead to inflation. Increasing the money supply will lead to devaluation of the currency. The devaluation of a national currency will have a dire consequence to the economy since the currency will have no power over other currencies. This will lead to a higher exchange rate of the national currency with other currencies; this will affect the price charged per service or commodity. Therefore, this will lead to inflation. Therefore, the influence of a budget deficit leading to inflation will highly depend on the financial stability of the economy.
Unemployment occurs, when individuals in an economy do not have work and are continuously seeking employment opportunities. The unemployment rate describes a measure of the frequency of unemployment; the rate is usually obtained through dividing the number of unemployed persons by persons in the labor force (Mankiw, 2012). In dealing with the issue of unemployment, the government may opt to use either monetary or fiscal policy in solving the unemployment rate. Also, the government can utilize both policies in solving the issue. It is possible for the government to use either monetary or fiscal policy in pushing the unemployment rate below a given rate. However, it is not possible to keep the unemployment rate permanently below a certain rate, for instance, 5%. The fiscal policy works through the use of government spending and taxation in influencing the working of the economy. The government may use expansionary fiscal policy in pushing the unemployment rate below a certain rate. The expansionary fiscal policy will have an effect of increasing the aggregate demand, which will lead to relatively high output. The substantially high output will have an effect of generating more job opportunities. It is through the generation of more job opportunities that will lead to pushing of the unemployment rate below a given percentage level. However, the unemployment rate cannot remain permanently below the given rate since classical economists argue that; the fiscal policy will likely cause a temporal increase in the real output. In the short run, expansionary fiscal policy will have an effect of temporary increasing the real output. This will be responsible for pushing the level of unemployment below a certain rate. However, the effect will not last in the long run. In the long run, an expansionary fiscal policy will be responsible for causing inflation and will not increase the real output.
Therefore, in the long run, the expansionary fiscal policy will not be capable of maintaining the unemployment rate below the rate attained during the short run. Therefore, it is not feasible to apply a fiscal policy, which will be capable of maintaining the unemployment rate below a given rate. On the other hand, policy makers argue that monetary policy can be used in pushing the unemployment rate below a certain rate. However, this cannot be maintained on a permanent basis. Increasing the money supply in the economy will lead to an increase in output, which will foster job creation. Creation of employment opportunities will have the effect of pushing the unemployment rate below a given rate. However, this will only occur in the short run; since in the long run, the monetary policy will have negative impacts to the economy since there will be wage and price inflation. This implies that the level of unemployment, which was previously set below a given level, will rise above the level. In the long run, the monetary policy will not cause an increase in real Gross Domestic Product; since there is wage and price inflation, the level of unemployment will increase above the rate in the short run. Economists and policy makers argue that applying monetary policy in resolving the problem of unemployment will only resolve the crisis in the short run. In the long run, the monetary policy is likely to cause an increase in the inflation rate. Therefore, the use of monetary and fiscal policies cannot permanently push the unemployment rate below a given rate.
Exchange rates describe the rate at which a country’s currency is exchanged with another country’s currency. Different countries have varying currencies, which have varied rates at which they exchange with subsequent currencies (Mankiw, 2012). For instance, the U.S. dollar has a given rate at which it can be exchanged with Sterling pounds. The relative worth of a given currency in terms of another currency indicates the exchange rate of the currency in regard to the other currency. The rate between any two currencies usually changes with time. It is remarkably impossible to maintain a constant exchange rate between two currencies. In the last decade, several factors have influenced the fall of the value of the dollar in the international market. One of the factors that led to the fall of the dollar value in the international market is the performance of the U.S. economy. The worth of the dollar is grounded on its demand compared to other currencies. Incase more individuals desire to have dollars, the rise in demand will have an effect of triggering a rise in price. On the other hand, if the demand falls, the value of the dollar will also drop. In the last decade, the economy of the U. S. was not performing well since there were various economic down turns. This made investors believe that the economy of the United States was going to decline. This made most investors pull their money out of the economy leading to collapse in the value of the dollar. Foreign economies also played a part in the decline of the value of the dollar.
Investors usually choose to put their resources in currencies, whose economies are booming. In the last decade, the European economies were booming, which made investors prefer putting their resources in the form of European currency. This led to the falling price of the U.S. dollar. Part of the declining dollar value is traced to an imbalance existing between the amounts of commodities that the United States imported compared to the number of commodities exported. In case a country imports more than it exports, there is a likelihood of a trade deficit occurring. In the last decade, most of the United States imports exceeded imports; this led to a trade deficit, which drastically led to drop in the value of the dollar. Also, interest rate is another factor contributing to a collapse in the worth of the dollar. The interest rate at which banks offer to investors determines the price of the currency (Mankiw, 2012). In the last decade, the value of the dollar decreased since the rates of interest were relatively high; this made most investors prefer putting their resources in terms of other currencies. This made the price of dollar drop drastically. In addition, inflation is another chief factor that contributed immensely to fall in the price of the dollar. In the previous decade, inflation and fears of inflation made investors feel that they will not be capable of purchasing more commodities than the currency used to afford before. This negatively affected the price of the dollar leading to a collapse in the worth of the dollar. For instance, in 2008, most investors feared the consequences of a continued inflation. This led to investors gaining confidence in holding their investment in terms of other currencies. This led to the decline in the price of the dollar.
Mankiw, N. G. (2012). Principles of macroeconomics. Mason, OH: South-Western Cengage Learning.
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