Markets and the economy: structure and function

Markets & Economy

A budget deficit is an effective means of stabilizing the economy during periods of recession. The accounting identity for GDP is C + I + G + X -- M, reflecting consumer spending, business investment, government spending, exports and imports. The total of these components will be the GDP of the country. In times of recession, both consumer spending and business investment are likely to be down. Consumer spending is down because unemployment is up, and even employed workers curtail their spending out of fear that they may be next to lose their jobs. Business investment is down because consumer spending is down, meaning that the economy has excess capacity. What government spending does in this situation is it helps to make up for the downturns in business investment and consumer spending. Consider the following example:

If before the GDP is 100 and consists of 40 + 40 + 10 + 20 -- 10. If C. And I both decline by 5, the new GDP would be 35 + 35 + 10 + 20 -- 10 = 90. Government in this situation would increase its spending to 20 in order to restore the GDP to 100. Whether this is desirable as a point of public policy is for the government to determine, but economically, government spending in this situation does help to restore balance to an economy in recession.

Another reason why a federal deficit can be valuable to help stabilize the economy is because it preserves long-run taxation power. Government receipts are dependent on economic activity -- so spending to maintain business capacity utilization and keep the unemployment rate down will have an immediate impact on long-run tax receipts. In addition, long-run excess capacity will result in plant closures and layoffs. Once a plant is closed for a year or two, or a worker unemployed for a year or two, it becomes more difficult to restore that capacity to the economy at a later point. This depresses tax receipts in the long-run, so government spending today can help to avoid this. The idea with deficit spending is to preserve the ability of the economy to generate surpluses, which can then be used to pay down the debt that was incurred during the recession times.

2. Adjustments in wages and prices can move an economy from short-run equilibrium to long-run equilibrium. The short-run equilibrium point is at the point where short run aggregate supply intersects with short run actual GDP. The SR aggregate supply is based on the expected price. The new aggregate demand is also going to be at the short-run equilibrium point, as the market sets this demand based on the short-run price. This point, however, is at a higher price level than was expected.

Wages are stickier than prices, so will lag slightly. They will be pressured upwards towards the short-term equilibrium point. However, to attain long-run equilibrium, prices will need to decline in order to meet the wage level. This will also facilitate increased competition, as new entrants to the marketplace drive prices down in order to gain market share. With lower prices, aggregate demand will increase and aggregate supply will decrease. This movement pulls the market into long-run equilibrium.

3. The reason why a system of marketable pollution permits leads to less costly pollution abatement is simple economics. In short, the system will encourage pollution abatement from the firms that have the lowest unit-cost of abatement. Pollution permits would reflect specific pollution outputs that are allowed. If these are marketable, then firms will be compelled to choose between polluting, or addressing the pollution. Rational firms will choose the lowest-cost option between the two. The market is expected to be efficient, so that while some firms will find it cheaper to pollute, other firms will find it cheaper to install pollution abatement mechanisms.

Ultimately, the system will seek to deliver the lowest per-unit cost of abatement. This will be achieved because the firms that are going to abate their pollution are the ones for whom the cost of abatement is lower than the cost of polluting. With these firms focused on their abatement efforts, they will deliver a greater degree of pollution abatement at a lower per-unit cost with the marketable permits than any other system.

To see the value in this system, the alternative must be considered. If firms are mandated to reduce pollution, they will do so to bring themselves under the maximum allowable pollution levels. However, firms will have no economic incentive to reduce pollution below the mandated maximum level. Thus, while some abatement will occur, this amount will effectively be capped at the current level of surplus pollution. The marketable permits provide economic incentive for firms to continuously reduce their pollution levels. Firms that can reduce more, and more cheaply, will do so, the result being a net reduction in pollution when compared to alternative tactics.

4. GDP measures economic output, but there are many types of output that are not included in the GDP measures. These other outputs, however, can have a significant impact on our quality of life. Therefore, the following three additional outputs are proposed. The first is pollution. Pollution is typically an externality that is not included in the GDP but which can have a substantial impact on quality of life. Pollution would be subtracted from the economic indicators in the GDP, reflecting the reality that x level of growth with less pollution is more desirable than x level of growth with more pollution.

Another measure would be a freedom index, reflecting civil freedoms in society. Civil freedoms are contributed to by both government and the people. If laws are passed to improve freedoms such as freedom of speech, freedom of the press, and any other personal freedom to act in a way that does not do harm to others, then this should be added to the GDP. It is important that society recognize the value of improving freedoms and strive to provide even greater freedoms in the future.