Table of Contents
Monetary Policy Fiscal Policy Issues Encountered by the Government Arguments for a Free Market System: Netherlands Market Failure Causes Response of the Netherlands to Market Failure References
In Greece, the recent recession had a negative impact on both the commercial and public sectors (Athanassou, 2009, pp. 364-372). The financial markets lacked adequate loan facilities and liquid assets. In contrast, the public sector had a massive budget deficit. As a result, the government is currently heavily indebted as a result of its inability to return the monies it acquired via various credit arrangements (Sakellaropoulos, 2010, pp. 321-348). In response to this circumstance, the government made the following adjustments to its monetary and fiscal policies:
First, the Greek Central Bank utilized open market operation (OMO) in reaction to the country's financial crisis. OMO entails changing the availability of money in the economy by open market trading of securities (Clapham, 2007, p. 12). Thus, the central bank marketed numerous instruments to the public, including bonds and Treasury bills. Citizens and institutions that purchased the securities were required to repay their investments at a later date. This strategy was implemented primarily to enable the government to borrow money from the public in order to pay its budget deficit.
Second, the central bank decreased the reserve requirement rate (Sakellaropoulos, 2010, pp. 321-348). The reserve requirement is the proportion of commercial banks' deposits kept by the central bank. Thus, commercial banks were able to maintain a bigger proportion of their deposits (Sakellaropoulos, 2010, pp. 321-348). This indicates that they have more capital available for credit creation. Thus, the primary objective of this strategy was to increase the economy's liquidity through loan creation.
Thirdly, the central bank decreased lending rates (Sakellaropoulos, 2010, pp. 321-348). In this instance, the lending rate refers to the interest rate at which the central bank offers commercial banks short-term loans. This was intended to entice commercial banks to obtain short-term loans from the central bank (Clapham, 2007, p. 45). In 2009, the federal reserve cut the interest rate from 6% in 2008 to 5%. (Sakellaropoulos, 2010, pp. 321-348). In 2008, it was cheaper for commercial banks to borrow short-term loans from the Central Bank of Greece (Sakellaropoulos, 2010, pp. 321-348). Therefore, the low interest rate encouraged them to borrow additional funds for credit development (Sakellaropoulos, 2010, pp. 321-348).
In response to its enormous fiscal deficit, the government implemented austerity measures (Athanassou, 2009, pp. 364-372). Austerity policies are intended to reduce the level of the government deficit by reducing costs, and they were applied in Greece as follows: (Hansen, 2003, p. 47). First, the government lowered the salaries of public sector employees in order to save money (Athanassou, 2009, pp. 364-372). These savings were intended to assist the government in financing other development measures, such as education subsidies. Second, recruiting in the public sector was halted to prevent an increase in the deficit (Athanassou, 2009, pp. 364-372).
Third, the age of retirement was increased to 65 (Athanassou, 2009, pp. 364-372). Thus, the government was able to save money that would have been used to pay the pensions of retirees. Instead, the monies were allocated to other development activities. In the end, the government imposed additional taxes and raised the rates on the existing ones (Athanassou, 2009, pp. 364-372). This was intended to assist the government effectively fund its budget by generating more money.
The second measure involved fiscal policy expansion (Athanassou, 2009, pp. 364-372). This necessitated an increase in total expenditures. The surge in expenditures was financed with borrowed funds from the public, financial institutions like the IMF, and foreign nations like Germany (Athanassou, 2009, pp. 364-372). The primary objective of the expansionary fiscal policy was to stimulate economic growth. In an effort to raise the country's real GDP, the government was interested in encouraging economic activity. This is due to the fact that a rise in total expenditures results in a rise in national revenue (Clapham, 2007, p. 46). Consequently, the real GDP rises as aggregate demand increases. The rise in real GDP indicates that the economy is experiencing expansion.
Difficulties Encountered by the Government
The steps taken by the government and the Central Bank of Greece resulted in the emergence of new issues that impeded their ability to achieve their intended objectives (Nelson, Belkin and Mix, 2010, pp. 1-18). The new issues can be described as follows.
Initially, open market operations were utilized to raise revenue for government expenditures from both domestic and international markets (Nelson, Belkin and Mix, 2010, pp. 1-18). Even if the monies were utilized to encourage economic activity, little has been accomplished. In addition, there was fiscal mismanagement and incompetence within the government (Nelson, Belkin and Mix, 2010, pp. 1-18). This indicates that the government has not collected sufficient tax income. As a result, the government deficit has increased rather than decreased. As of 31 December 2010, the deficit reached 12% of the country's gross domestic product (Nelson, Belkin and Mix, 2010, pp. 1-18). In addition, the government has been unable to pay its maturing debts.
Second, the expansionary fiscal policy brought about a decline in the country's exports (Nelson, Belkin and Mix, 2010, pp. 1-18). To support its expansionary fiscal policies, Greece issued bonds on the international financial market (Nelson, Belkin and Mix, 2010, pp. 1-18). Consequently, Euro demand soared on the international financial market (Nelson, Belkin and Mix, 2010, pp. 1-18). In 2009, when the fiscal strategy was enacted, the Euro's value increased by 13% in response to a rise in demand (Nelson, Belkin and Mix, 2010, pp. 1-18). As a result, Greek commodities became more expensive on the international market than they were before to the policy's implementation. This is because importers of Greek goods had to pay a premium for the Euro in order to pay for the goods. The products' high price diminished their demand.
Greece's import prices decreased as a consequence of the Euro's appreciation. This is due to the fact that importers purchased foreign currency at a lower rate to pay for the items (Krugman and Wells, 2009, p. 69). Overall, the result was a decline in exports and an increase in imports (Chrisochidis, 2011, pp. 144-162). Because to the expansionary fiscal policy, the inflation rate climbed from 4.4% in 2009 to 5.2% in 2010. (Nelson, Belkin and Mix, 2010, pp. 1-18). Thirdly, because the nation was functioning at full capacity, the expansionary fiscal policy led to an increase in inflation (Blanchard, 2008, p. 89). This is depicted in picture 1. As previously established, a rise in aggregate expenditures leads to a rise in aggregate demand. Consequently, as the equilibrium income increases from Y1 to Y2, so does the price, from P1 to P2. Thus, the price increase indicates an increase in inflation.
Figure 1: model of supply and demand
P: pricing level Y: national income AS: aggregate supply
Figure 2 illustrates how the increase in government expenditures also contributed to an increase in interest rates. Similar effects are produced by an increase in total expenditures and a decrease in savings (Boyes and Melvin, 2007, p. 193). This impact causes a surge in demand for certain products at varying interest rate levels (Blanchard, 2008, p. 90). This implies that the IS curve will rise if the government raises spending, as depicted in Figure 2 below (Blanchard, 2008, p. 90). As the curve changes to the right, the equilibrium rate of interest increases from I1 to I2. The increase in borrowing rates inhibited investment by the private sector. Thus, the objective of long-term economic growth was not met due to the increase in interest rates.
Figure 2: IS-LM model
I: yield to maturity Y: national income IS: curve of investment savings LM: curve of liquidity and money
Finally, the austerity policies brought about the following economic growth setbacks: The recruiting freeze in the public sector led to a rise in the unemployment rate. The drop in earnings or compensation of public sector personnel led to a decline in the economy's standard of living and quality of life. Due to a drop in discretionary income, the impacted citizens were unable to maintain their customary standard of living (Krugman and Wells, 2009, p. 69).
Netherlands – Arguments in Favor of a Free Market System
A free market economy is one in which the distribution of resources is determined by the forces of demand and supply (Baumol, 2002, p. 13). It is defined by private property ownership and minimal government involvement or intervention. The purpose of limiting the government's role in the economy is to boost efficiency and foster rapid economic growth (Baumol, 2002, p. 14). The government's responsibilities include regulation, law enforcement, and consumer protection against potential exploitations (Baumol, 2002, p. 15). The allocation of resources in the Netherlands is based on the advantages of the free market system.
First, the free market system allows individuals to make independent decisions regarding production and consumption (Gravelle and Rees, 2004, p. 104). Since there are no production restrictions, businesses are free to choose which industry to enter. Moreover, they have the authority to determine what and how much to create. Consequently, they have the ability to establish competitive advantages since they may utilize their maximum capacity (Gravelle and Rees, 2004, p. 104).
Moreover, they can control their expansion plans by modifying their manufacturing capacities as required (Gravelle and Rees, 2004, p. 97). The consumers, on the other hand, gain from a vast selection of items. This is due to the fact that the free market system is associated with product differentiation and mass production of various goods (Gravelle and Rees, 2004, p. 98).
Second, the system of the free market increases efficiency. As a result of the absence of entry barriers, the degree of competition increases as more companies enter diverse industries (Griffiths and Wall, 2011, p. 67). This motivates incumbent businesses to increase their efficiency in order to minimize expenses. This results in the efficient use of resources.
Thirdly, the innovation that results from the free market system's rivalry (Griffiths and Wall, 2011, p. 81). As rivalry increases, companies want to position their products as the best on the market. This necessitates a focus on the most efficient production methods in order to reduce costs while maintaining or enhancing product quality. Companies that cannot increase their competitiveness through innovation and cost reduction typically incur losses or even fail (Griffiths and Wall, 2011, p. 82). In order to develop better industrial technology, the Netherlands invests considerably in research and development for this reason (Melvyn and Lee, 2000, pp. 104-113). This results in product and process innovation that is advantageous for both customers and producers.
The free market system results in the highest product quality and lowest prices (Baumol, 2002, p. 25). This is due to the fact that demand and supply factors give customers the power to determine what will be produced (Baumol, 2002, p. 26). In a free market, the production of goods and services is influenced by consumer tastes and preferences (Baumol, 2002, p. 27). This indicates that low-quality commodities will be rejected due to a lack of demand, and their supply will cease as a result. Due to the competitive nature of the market, vendors will reduce their prices to attract buyers (Baumol, 2002, p. 28). For instance, food prices in the Netherlands are quite low due to the abundance of food providers (Melvyn and Lee, 2000, pp. 104-113).
Lastly, profit maximization is related with the free market system (Griffiths and Wall, 2011, p. 72). Since the prices of products and services are controlled by market forces, sellers can generate substantial profits. This is because businesses can raise prices when demand is high in order to boost their profits. In addition, they are able to develop their production elements in a manner that increases productivity (Delson and Poutsma, 2005, pp. 169-196). For instance, Dutch producers focus on worker training and the use of contemporary technologies to increase their efficiency (Delson and Poutsma, 2005, pp. 169-196). This results in substantial earnings.
Reasons for Market Failing
Market failure is the condition in which the free market system is inefficient in allocating resources (Cowen and Crampton, 2002, p. 80). This transpires as follows: Due to the non-rival nature of public goods, their presence results in market failure (Winston, 2006, p. 49). In addition, merchants typically lack the ability to regulate access to or usage of public commodities. Consequently, the free market system does not provide these items. Also contributing to market failure are merit products such as education. These items may be underutilized if supplied only by the private sector (Winston, 2006, p. 50).
Greater social benefit is related with the use of merit goods than private advantage. This results in market failure because social and private benefits are out of balance (Winston, 2006, p. 51). The presence of monopoly can also result in market failure, as detailed below. Due to the absence of competition in a market with monopolistic tendencies, prices will exceed the equilibrium level. This has a negative impact on the quality of life of the residents (Winston, 2006, p. 52). Consequently, the market will not allocate resources efficiently.
Ultimately, the failure is due to external factors (Winston, 2006, p. 54). External benefits result in underproduction of a product since consumers and producers never account for them (Winston, 2006, p. 55). Conversely, negative externalities result in the overproduction of a product (Mankiw, 2008, p. 78). This is because market agents do not cover these expenses. Figure 3 depicts the influence of negative externalities.
In this instance, the marginal cost of the private sector is less than the marginal cost of the public sector (Winston, 2006, p. 54). This is indicated by the separation between A and B. This is inefficient because the optimal price and quantity are P2 and Q2 correspondingly. Figure 4 exhibits positive externalities. In this instance, the marginal benefit of the private sector is less than that of the public sector.