Fiscal Policy Expansionary and contractionary are two types of fiscal policy. Expansionary policy involves raising government expenditures and lowering taxes so the government budget deficit can grow or the surplus to fall. In 2011, Japan suffered from a natural disaster. The north east area of the country was struck by a tsunami causing their country to endure financial issues. Japan used expansionary fiscal policy to help get them out of that terrible economic situation. Expansionary fiscal policy helped Japan by raising their private consumption growth. Contractionary fiscal policy is the opposite of expansionary policy. Government expenditures will be decreased and taxes will be raised to help the budget deficit or surplus.
The Role of Government Budgeting One of the main tools of fiscal policy is the federal budget. Aggregate demand is affected by the government expenditures and taxes affect investing and consuming. The effects of government expenditure and tax revenues are important in the aggregate demand equation because they can cause AD increase or decrease. “Government expenditures include transfer payments, purchases of goods and services, and interest payments on government debt” Swanenberg. Tax revenues are brought in from social security, indirect taxes, income tax, and corporate taxes. When the amount of taxes brought in is above expenditure expectations, this will factor to a budget surplus.
Fiscal Policy Pros and Cons Fiscal policy is the usage of government spending and the use of taxes to control the economy. As defined by Investopedia, “fiscal policy is the means by which a government adjusts its level of spending in order to monitor and influence a nation’s money supply,” (2009). Whenever the government makes a decision on what service and good to buy, how much to tax on said good or service, or the payment relegations dispersed, the government is exercising the fiscal policy. The fiscal policy is mostly used to show how government spending and taxation affects the aggregate economy levels. The fiscal policy really was not used as much until after World War II. “When there is a surplus in the government budget, (revenue is higher than spending), the fiscal policy is a contradiction whereas when there is a deficit in the budget, (spending is higher than the budget), the fiscal policy is defined as being expansionary,” as stated by the Library of Economics and Liberties (Weil 2008). The Library of Economics and Liberties also states, “when there is a deficit in the fiscal policy, economists focus more on the difference in the deficit and not the levels of the deficit,” (Weil 2008).
The fiscal policy however is not perfect. Just like everything in nature, the fiscal policy has its strengths and weakness. According to Dr. Wood, one main strength about the fiscal policy is that since it is basically government ran, “it has good stability when used properly in the economy” (Wood 2009). Contrary to monetary policy, the fiscal policy focuses on one area instead of the economy as a whole which can result in less mistakes and less headaches. Government interaction aids the fiscal policy by helping with resource allocation.
As mentioned before, the fiscal policy is not perfect. Because the fiscal policy deals with the government, there may be little to no room for flexibility, (Wood 2009). An example would be, the government can’t decide to raise taxes to compensate government spending. David Weil has stated that, “fiscal policy also changes the burden of future taxes,” (Weil 2008). The fiscal policy can sometimes result in the “domino effect,” meaning having one problem can cause more problems, which can result in another problem, and so on. The fiscal policy is usually only implemented once a year so this itself can be a weakness. One reason is because the government may be funding a project, such as a highway being built, and may not be finished in the allotted time, thus causing a problem in government spending. As of October 2012, Forbes has elucidated that the fiscal policy is not as effective as it once was by stating, “the Central Bank can’t lower its interest rates,” (Smith 2012). Smith also goes on to state that, “if the government steps in and borrows lots of money then the rate of interest will tend to rise,” (Smith 2012).
Monetary Policy After the Great Depression, market economies learned that they were not adjusting to economic downturns quickly enough. The lack of response was one of the causes of long-lasting economic crises. Therefore the government started to stick its hand in the economy to keep it from spiraling out of control using fiscal policy. When GDP contracts, the government spends more, and taxes less, which gets the economy growing. Another form of government macroeconomics is monetary policy and it is practiced by the Federal Reserve Bank. The Fed fiddles with the money supply to keep the economy in between inflation and recession.
Back in the 1960’s President Johnson had to increase government spending due to the Vietnam War. Economists believed as the President kept spending money, it would lead to inflation. The inflation would be caused by an economy that is already stable, plus increased government spending, which only creates higher prices and aggregate supply will be limited. The Federal Reserve Bank and monetary policy was then instituted. Its job is to make the necessary corrections in the economy that the government will not make. The Fed is a private sector.
The Federal Reserve Bank affects the economy’s rate of interest. Our central bank increases the amount of money circulating in the economy because the higher quantity of something decreases its price. With a lower price of money, also called a lower interest rate, more people will be willing to borrow money, which means they spend more money in turn giving the economy a boost. The only problem is some economists believe it will cause prices to spike quickly. So out of fear of inflation, the Fed decreases the amount of money circulating in the economy which raises the price of money, or raises the interest rate. Higher interest rates mean less borrowing, which means less spending, which slows the economy down. Now the fear is the economy will fall into a recession so the Fed lowers interest rates again.
The Fed raises the interest rate out of fear of inflation which then causes Recession. The Fed lowers the interest rate out of fear of recession which then leads to inflation. The Fed controls the money supply, which increases or decreases interest rates that can potentially boost or slow an economy and the Fed must keep a good balance because one direction is recession and the other is inflation.
Overall monetary policy plays a big part in our economy, without it there would be a lot of confusion in the business world. In particular, the main one would be the banking system. The Federal Open Market Committee (FOMC) is the body that’s responsible for most of the monetary policy decisions that are made. Monetary Policy has to do with recession and inflation which is very important in our economy. Another important fact about monetary policy is aggregate supply and demand. Monetary policy affects them deeply depending on the economies input, output, and rate of inflation.
Strengths and Weakness of Monetary Furthermore, monetary policy that is speedy and flexible and somewhat isolated from Political pressure. It doesn’t raise inflation value of money by weaken its purchasing Power. Whenever inflation advance faster than expected, they may sell government bonds to take money out of circulation. This also can minimize access to credit and slow consumer spending. The decisions they had made really had an effective impact on our economy. Monetary policy has stable prices which is keeping inflation low, it also quality business and households to make financial decisions without worrying about sudden unexpected prices increasing. The long term enable policy makers assess. The best policy tends to seek between these short- and long- term goals. Lower interest rates to expand the money supply and stem rising unemployment Rates during recession. Although the weaknesses practicing monetary policy cause the central bank to lose control of currency valuation, it wouldn’t be possible for interest rates. It also devalues the currency; further more monetary policy can achieve low inflation in the long run and affect economic output and employment in the short run. Sustainable Low inflation and economic growth off disagree. When inflationary pressures decrease, the unemployment rate may advance for a short period as the pace of the economy slows. It also can take up to months or even an year maybe even longer to have the intected effect.
Conclusion Monetary and Fiscal policy both have their pros and cons. Fiscal policy can result in a nasty domino effect causing one problem to make another and repeat. Fiscal can also have issues with time lags. Although monetary policy is not very effective in a recession, it is flexible and works well to slow down the economy. Many prefer fiscal over monetary because its brings low taxes and low interest rates.
Cournot Bertrand And Stackelberg Models Of Oligopoly Economics Essay
Generally in oligopoly competition, it is assumed that there are a fixed number of firms and no new entry; all firms produce homogenous product in a single period and have constant marginal cost c. In the Cournot model, firms choose the quantities to produce and prices adjusted along to clear the market. In Bertrand model, firms set different prices for the same product so the firm that has the lowest price can sell to the whole market.
Consider a duopoly case where there are two firms in the market. Suppose that Firm 1 sets p1 and Firm 2 sets p2 above the marginal cost (MC). For given p1, if p2 is slightly lower than p1, all consumers will buy from Firm 2 and Firm 1 sells 0 as two firms produce identical products. If p2 is higher than p1, no one will buy from Firm 2. If p2 = p1, consumer’s preference is indifferent between two firms.
Figure 1: A Bertrand Firm’s Residual Demand As shown in Figure 1, Firm 2’s residual demand curve equals to 0 if p2>p1, coincides with the market demand curve when p2<p1. When p2 = p1, two firms share half of the market demand which is indicated by the dashed line.
Since MC is constant and total cost equals average cost (AC) times quantities produced, therefore MC = AC = c. Suppose Firm 1 sets p1 > p2 > c then it will sells 0. So Firm 1 is better off deviating and charging p1 below p2. When Firm 1 charge p1 = p2 = p >c, demand is divided equally between two firms, both firms earn profit π1 = π2 = (p-c)*1/2Q(p). But if Firm 1 lowers p1 to slightly below p then it will sell to the whole market and earn almost double profit π1 = (p-c)*Q(p). So it will do better by deviating. There is a possibility where Firm 1 charges p2 > p1 = c and earns zero profit since it produces where price equals AC. Then it will earn positive by raising p1 to just below p2 but above c. The same case goes to Firm 2. In these situations, both firms can be better off deviating and changing its price level. Thus none of them can be the Nash Equilibrium. This is illustrated in Figure 2 below.
Figure 2: Bertrand Best-Response Functions Source: http://users.ox.ac.uk/~scat3104/oligopolynotes.doc
Given p1, Firm 2 will choose p2 slightly below p1 but above MC, therefore, Firm 2’s best-response function lies slightly below the 45° line, where price equals MC. If Firm 1 set p1 below MC, then Firm 2’s best-response is to do nothing to prevent losses. Similarly, Firm 1’s best-response function lies just above the 45° line. The intersection of the two functions is where both firms charge p1 = p2 = c and neither of them would want to deviate because if one wants to lower its price, it will gain losses but if it tries to higher the price, it will earn zero sales. Hence, no firm can do better by changing price. This is the unique Bertrand Equilibrium where firms set prices equal to MC and all firms gain zero profit, similar to the social optimum. The outcome is equivalent to the outcome in competitive market where there’s no market power. This is called the Bertrand Paradox. It is hold regardless the number of firms
However, the assumptions of Bertrand’s model ignored some important facts in real world market. As assumed, products are homogenous and MC is constant, one firm can fill the market demand if its price is slightly below rival’s price. But in real market, this is unrealistic since firms have limited capacities. In 1897, Francis Edgeworth showed that if there are capacity constraints, the Bertrand Paradox may not hold. His model was based on Bertrand duopoly model excepting that both firms are capacity constrained. Suppose that firms can only produce a certain level of output qc and it is very costly to produce beyond that level. So up to qc, MC is constant but it becomes infinite at qc.
Figure 3: Bertrand Residual Demand with Capacity Constraints Suppose that Firm 2 sets p2 equal MC: p2 = c. Believing that Firm 2 charges p2, Firm 1 will not respond because it will make losses by lowering p1. And if it sets p1 > p2, then all consumers will by from Firm 2. Since Firm 2’s capacity is constrained, it can only sell the amount qc. There will be consumers who are turned away by Firm 2. These consumers may be willing to buy from Firm 1 at higher price p1. Therefore, Firm 1 will sell the amount equals market demand minus qc, which means Firm 1’s residual demand curve is the market demand curve shifted left-ward by qc. Thus, Firm 1 can maximise profit by acting as a monopolist and charges p1 where MR = MC. At this price, Firm 1 can make positive profit. Hence, the Bertrand equilibrium is not hold in this case.
If two firms charge the monopolist price p1, one firm would want to lower its price to slightly below p1. This way, although it can’t fulfil the market demand, it still gets higher demand than its rival, thus, earns higher profit compared to setting price equal MC. Consequently, setting price equals monopoly level is not a Nash Equilibrium.
Consider the case where the total capacity of two firms, q1 q2, is comparatively small to the market demand. And suppose that p is the price where market demand is equal to the total capacity, Q = q1 q2, and Firm 2 charges p. If Firm 1 also charges p1= p, its profit will be π1 = q1*p. If it charges p1
p, its residual demand will equal the market demand minus Firm 2’s residual demand, Q – q2, similar to the case above. Since the total capacity is small, Firm 1 can do better by not raising p1 above p. So Firm 1’s best-response when Firm 2 charges p2 = p is to charge p1 = p and vice versa. In this case, p1 = p2 = p is the Bertrand-Edgeworth Equilibrium. On the contrary, when the total capacity is large compared to market demand, if firms try to set price equals to MC and share half of the market demand, their capacities will not be fully consumed. So firms would try to deviate to gain more consumers. The situation goes back to the Bertrand outcome.
Generally, if capacity constraints exist, there is no static equilibrium i.e. no equilibrium in pure strategies since prices may fluctuate or firms may choose to use mixed strategies. Apart from that, the size of capacity influences the competitiveness of the industry, the smaller capacity constraints, the higher market power.
Up until now, capacity constraints have been considered exogenous. Assume that firms endogenously choose capacities before setting price. This is a two-stage game which firms simultaneously choose a capacity in first stage, then choose prices in second stage. This means that firms engage in Bertrand-Edgeworth competition, and therefore can avoid the Bertrand Paradox. According to Kreps and Schienkman (1983) and Deneckere and Kovanock (1996), under some conditions, the firms’ capacity choice in Edgeworh’s model leads to equilibrium prices which are similar to those arise in Cournot model. If the capacity and production cost are relatively high, the unique Cournot equilibrium occurs.