Effects on the U.S. GDP from Raised Input Prices and Government Methodology for Stabilization in the Long and Short Run

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1 Sample Term Paper 1 Effects on the U.S. GDP from Raised Input Prices and Government Methodology for Stabilization in the Long and Short Run Name: kh Section: BQP - 2pm TA: Sahan Dissanayake Article: Oil crisis drags down GDP growth Date: 4/21/2006 Journal: The Manula Times 1

2 Introduction: While the total output of the macro-environment is a vast consummation of all the products and services from the industries within a nation, it is a sensitive entity that can be affected by changes in an individual market. In the case where a base industry provides raw materials or factors of production to a variety of other industries, price changes in this critical industry can significantly alter the price level and output of the macro-economy. An example of an industry that provides raw materials to other industries is the oil market because so many other industries (automobile, heating, lubricant, etc.) rely heavily on inputting oil as a means of creating their specific product. If the price of oil increases, the corresponding input costs for many different products, which rely on oil as a component, rise as well. This increase in the economy s input prices shifts the aggregate supply curve of products produced to the left. The aggregate supply curve is a graph that shows the relationship between the total quantity of products or services supplied by all firms in the economy and the overall price level. The consequent decrease in the aggregate equilibrium of quantity supplied within the economy, which is concomitant to the leftward shift of the aggregate supply curve, leads to an increase in the overall price level (inflation) and a decrease in the total output of the macro-economy. While the quantity of imported crude oil into the U.S. has decreased by 8.6%, the price of imported oil has significantly increased, which has created a large overall increase (27.2%) in the amount spent by the U.S. on imported oil. Assuming ceteris peribus (all else equal) in the other industries, and assuming that there exists an overall increase in the total amount of money spent on imports, this phenomenon would generate an overall decrease in the GDP of the U.S., according to the expenditure method of calculating GDP. This is due to the fact that the expenditure method of calculating GDP uses the net exports (exports imports) as an addition 2

3 element which is directly related to the overall output; therefore, if imports increases, net exports will decrease and GDP will decrease (again, assuming ceteris peribus). In order to compensate for the decrease in the equilibrium aggregate output of the country, the government can intervene by focusing on growth policies. By setting a target increase in GDP of 6.3% in 2006, the government can take action by provoking short-term growth in the economy through strategically manipulating the monetary (changes in the money supply) or fiscal policy (changes in government spending or taxation). Monetary policy is controlled by the Federal Reserve Bank (the Fed), whereas fiscal policy is controlled by Congress and the President). By performing three different actions (increasing the money supply, increasing government expenditures, or decreasing net taxes), the government can shift the aggregate demand curve to the right, which will in turn counteract the leftward shift of the aggregate supply curve (derived from an increase in input prices) and increase the total output of the nation. The aggregate demand curve is a graph that shows the negative relationship between aggregate output and the price level. As the aggregate demand curve shifts to the right, the shortterm output of the economy increases, which will assist the government in achieving its current 2006 target increase in GDP of 6.3%, which is quite larger than the average annual increase in GDP over the past century of 3.4%. Theory Review and Analysis: In order to measure the total output of the U.S., economists use a number of tools; one of the most important and accurate measures is the GDP (Gross Domestic Product). The Gross Domestic Product measures the total market value of all final goods and services produced within a certain period of time (in this example, yearly) by factors of production which are located within a specific country such as the U.S. As a means of calculating the annual GDP, 3

4 one can measure the total amount of income (the income approach) or determine all of the expenditures that have been generated (the expenditure approach) for the nation within a given year. The expenditure approach is a very useful tool because it provides a mathematical relationship for all of the factors of spending; therefore, the short-term affects of changes in monetary or fiscal policy can be clearly seen by manipulating the variables. The expenditure formula for calculating GDP can be seen as follows: GDP = C + I + G + (Ex-Im), where GDP=Y=Gross Domestic Product (short-term) G=Government Spending, C=Consumption, I=Planned Investment (Ex-Im)=Net Exports=Exports - Imports For the government to intervene and change the above variables, they can take several actions; these measures will ultimately increase or decrease GDP in the short-run. In order to achieve a target increase in GDP for 2006 (which is the plan of action that government wishes to take according to the article), the government should take the actions that can be seen in the Appendix of this paper. The government can increase the money supply by decreasing the reserve requirement (the percentage of money that commercial banks must keep on reserve), decreasing the discount rate (the interest rate that commercial banks pay to borrow money from the Fed), or buying government securities on the open market. An increase in the money supply leads to a decrease in the interest rate (r) as seen in Graph 1. The interest rate has a negative relationship with planned investment (r); therefore, a decrease in the r corresponds to an increase in I as seen in Graph 2. Since I increases, the equilibrium output (Y) in the goods market increases. Increasing the amount of government spending implies that G increases, which raises the equilibrium level of Y as seen in Graph 3. If the government decreases net taxes (T), more 4

5 money is given back to households and firms who then consume more (increasing transactions) and invest in capital.therefore, a decrease in T corresponds to an increase in C as seen in Graph 4. All of the previous actions also correspond to a rightward shift in the aggregate demand curve. If the variables change enough to shift the aggregate demand curve to the right and counteract the leftward shift of the aggregate supply curve (caused by the increase in imported oil or input prices), the short-run GDP will increase as seen in Graph 5. It is important to note that changes in fiscal and monetary policy will only alter the shortterm output of the economy. This is due to an economic theory which suggests that the long run aggregate supply curve is vertical. A fixed vertical long-run AS curve implies that any rightward movement of the aggregate demand curve, which is associated with expansionary fiscal or monetary policy, does not alter the equilibrium quantity of output demanded (Yd) since Yd=Ys = equilibrium quantity of output supplied = constant as seen in Graph 6. Therefore, the government has the ability to achieve a target increase in GDP only in the short-term because the short-term aggregate supply curve is upward sloping. In the long-term, the government is incapable of inducing an impact on the output of the country. Conclusions: There exists an ongoing struggle over imported energy, which continues to raise the price of crude oil and therefore raise the input costs of the U.S. macro-economy. In light of the decrease in GDP caused by the increase in input costs and associated left-ward shift of the shortrun aggregate supply curve, the government may direct their energy towards achieving a 2006 target increase in GDP since this change in GDP is in the short-run. In order to achieve this target increase in GDP and raise their political reputation among the public, they can enact a combination of different fiscal or monetary policies. However, these actions will only satisfy 5

6 short-term political popularity contests by changing the short-run GDP, and not realize any sustaining GDP increases in the long-term. The best methodology towards attaining a long-run increase in GDP, as opposed to a short-run 2006 increase in GDP, would be for the government to invest in research that would increase technology for using alternative sources of energy. If a cheaper, more abundant fuel source is discovered through scientific research, the production possibilities frontier (a graph that shows all the combinations of goods and services produced if all of society s resources are used efficiently) would shift outwards as seen in Graph 7. In addition, the short-run aggregate supply curve would shift to the right as seen in Graph 8; however, since oil is such a widely used component in many different industries, there could quite possibly be an increase in the long-run aggregate supply curve that would be concomitant to a substitute for oil. Therefore, it is my opinion that the government should devote much of their expenditures toward research in alternative fuel sources, which could have a long-standing impact on the macro-economy. While the mass public is mainly concerned with the present state of the economy, the importance of the future cannot be understated. A target increase in the 2006 GDP (stemming from an increase in government spending, decrease in taxes, or increase in the money supply) is mainly useful for satisfying short-term goals. Although these short-term goals should not be overlooked, I believe that research dedicated to solving the energy crisis would have a much more powerful impact on assisting the U.S. GDP, not to mention world relations. Therefore, I suggest that the U.S. government use expansionary monetary or expansionary fiscal policy to satisfy a short-run increase in GDP, while simultaneously investing a substantial portion of government expenditures in research for finding alternative energy, which could lead to substantially reduced input costs in the long-run. 6

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