Federal Reserve IMF CBO Forecast Aggregated Supply and Demand Is-Lm-Bp Models Term Paper

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Alan Greenspan's testimony starts with a comparison between the state of the U.S. economy in July 2004, time of his present testimony, and the state of the economy in February 2004, the time of his previous testimony in front of the U.S. Congress.

In February 2004, the main problem of the U.S. economy, as identified by Greenspan, was the fact that the company's increase in income and net profits were related to a better use of human resources rather than on an increase in employment. In other words, despite the fact that the economy was on the rise, it failed to produce new jobs. This was a direct consequence, in Greenspan's opinion, of the risks associated with increased employments, more notably "corporate accounting and governance scandals," a "decline in stock prices" and the overall "geopolitical tensions"

As compared to the unemployment situation in February 2004, the period up to July 2004 brought significant changes in that there were significant gains in nonfarm payroll employment, averaging 200,000 a month up from 60,000 a month in late 2003. On the other hand, a positive sign from the employment sector raises serious concern on the country's monetary policies and especially on inflation.

Indeed, going back to economic theory, an decrease in unemployment is likely to increase the average household income and, on the whole, the overall household spending. As spending rises, supporting a growing demand for products, the consumer prices are in danger of rising as well, giving birth to an inflationary trend which may destabilize the macroeconomic processes.

As Greenspan explains, another cause for an increase in prices, but only in the short run, is the tendency to increase profit margins by increasing prices. While this may have happened in late 2003 and the beginning of 2004, the trend is significantly decreasing in mid-2004, mainly because an increase in prices with a better profit margin motivation also increases the competition levels, with new companies more likely to adopt the same measures. This would, in turn, drive prices to a more reasonable level in a short period of time.

In terms of monetary policies, the United States have surpassed, in Greenspan's opinion, the period of economic recession which gave way to extremely low (below 1%) interest rates. Interest rates are more likely to gradually rise and still sustain any inflationist threats that may appear. Greenspan is for "a more neutral stance of monetary policy," concerned with dealing with long-term threats rather than possible short-term pressures.

The IMF report analyzes both the impact of the U.S. fiscal deficit on the rest of the world and the way the monetary policies applied within the U.S. affect the rest of the world. Additionally, it describes the implications of China's economic boom of the last past decade and how this is likely to influence the overall evolution of the global economy. In the context, we are interested in the first analysis.

In order to cope with the economic recession that started in 2000, after a period of 8 years of economic expansion (1992-2000), the U.S. federal government applied "active fiscal policies"

. These generally include two separate actions: tax cuts or governmental spending and both have the same motivation: encourage companies to create economic value and create the programs that will help turn away from the period of recession.

On the other hand, expansive fiscal policies have a disadvantage: they create a significant fiscal deficit. The reasons for this are quite simple. First of all, through tax cuts, the governmental revenues are significantly diminished. Second of all, governmental spending means additional costs, as there is a significant increase in budget allocated to different projects.

Corroborated with high military and security-related spending due to geopolitical tensions, the expansive fiscal policies, led to an increasing budget deficit, a 7% increase in the proportion of fiscal deficit to overall GDP from 2000. While the effect of the fiscal measures may be judged beneficial on the overall global economic recovery, the questions remain on whether the consequences of such fiscal policies, as they have been manifesting in the United States, will negatively affect in any way the global economy.

The report presents some of the more troubling consequences of the U.S. fiscal policies on the U.S. economy. First of all, some of the most obvious ones are a record high trade and current account deficits, which have steadily grown ever since 2000. In the medium term, these deficits decreased confidence in the U.S. dollar, with the direct consequence that some investors turned away from U.S. assets, while the exchange rate needed to be. Additionally, the expanding fiscal policies in the U.S. poise questions on the way they may influence interest rates worldwide.

As such, the report concentrates on the way the U.S. fiscal policy may influence and affect the world economy. According to the report, there are "four key channels"

that need close attention. The first channel is related to the increasing economic activity in the United States, due to fiscal measures encouraging such an activity. The probability is that this in turn increases worldwide international consumption through a demand-side effect and the fiscal multiplier. The fiscal multiplier is a concept that implies that demand and consumption increase by a multiple of the increase in governmental spending.

Second of all, an expansionary fiscal policy, equivalent to a "public dissaving" needs to be ideally compensated through a higher level of private saving (in my opinion, this is only partially true. If interest rates are gradually decreased, this should also encourage private borrowing for households and increase private spending). Because there is "an imbalance between total savings and investment," this eventually leads to an increase in interest rates in the U.S. and, eventually, abroad as well.

According to the IMF report, the first relationship we should mention between world and U.S. economies is associated with the degree to which foreign asset markets and U.S. ones are linked. Studies and evaluations have shown that correlations between real interest rates in industrialized countries are all positive, which means that if interest rates rise in the U.S., they will rise in other countries as well.

Third of all, the "incentives to work and save are affected"

. This is related to the supply-side and to the fact that tax cuts should naturally be an incentive for the company's to produce more and thus to increase supply in the sector of the economy in which they operate.

Finally, the fiscal policy previously presented (tax cuts and governmental spending) would also impact the evolution of the dollar, in the sense that a substantial pressure on the U.S. current account would most likely turn the dollar to a decreasing trend (as evidence has shown up to December 30, 2004, when the dollar had its lowest level against the Euro and the Japanese yen). The expansive fiscal policy in general should raise the exchange rate, but it generally happens over a short period of time, in the beginning, after the interest rates are increased. Over a longer period of time, however, tax cuts increase consumption, including individual consumption, which, in turn, increases imports as a way to cover overall demand. A higher import rate gives way to the current account deficit the U.S. faces nowadays and, in turn, to the need to adopt a weaker currency in order to boost exports.

The IMF reports insists on some of the negative consequences of the U.S. fiscal policy on global economy, mentioning especially the impact on developing countries and emerging markets. The economic logic of the report is quite simple. For the beginning, as I have previously mentioned, in the beginning and over a short period of time, the fiscal expansion strengthens the U.S. dollar. As most of the external debts of the emerging markets are denominated in dollars, this obviously rises the absolute amount they need to pay.

On the other hand, the subsequent increase in U.S. long-term interest rates will also increase the interest rate that emerging markets need to pay. The respective countries' balance sheets are affected, leading to "macroeconomic volatility and difficulty in servicing and repaying their debts"

Greenspan's testimony and the IMF Report practically linked the two faces of the same coin, by connecting fiscal policies (tax cuts, governmental spending) with monetary policies (raising interest rates to decrease inflation and consumption). The key connection is in Greenspan's remarks on the state of the U.S. economy in July 2004 and on the need to gradually increase interest rates.

Indeed, in my opinion, Greenspan's assessments are almost like the historic, real continuation of the IMF Report. After an expansive fiscal policy, after tax cuts and governmental spending that encouraged spending and investment, especially through a supply-side effect, the danger of future inflation lays way to more cautious monetary policies, with interest rates being raised from the lowest level of 1%. According to the IMF Report, this is most likely to increase interest rates in emerging markets as well, with all of the negative consequences associated with this.

In this…

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