Measuring Economic Health Memo

The use of Gross Domestic Product (GDP) to measure the business cycle

The Gross Domestic Product (GDP) may be described as the measure of the economy’s national income and expenditure for a given period of time, or the aggregate value of goods and services produced in an economy within a specific period of time, measured at arm’s length. Generally, GDP is never constant and will keep on fluctuating depending on the fluctuations in the production thus leading to a cyclic effect referred to as business cycle; there will be occasions when the economy will be experiencing high growth which will be then followed by economic contraction. Ideally, the level of real GDP at any given time will indicate at what stage of the business cycle the economy is in, e.g. expansion, peak, contraction, or trough.

The various components of the real GDP including consumption, investment, government expenditure, and net exports will be used to forecast the business cycle. A rising level of GDP will call for increased capital and labor thus boosting investment and employment. This will be followed by increased incomes for households and a rise in expenditure (consumption) which will lead to the peak phase of the business cycle, economic growth. However, when the economy is contracting, real GDP will be falling as investment declines leading to low production, rising unemployment, and declining wages which will result in a reduction in consumption (consumer expenditure).

However, the real GDP may be faulted as the right measure due to exclusion of certain measures such as leisure, a black market economy, environment, security, and quality of goods; these factors also contribute to the direction the business cycle takes but are never accounted for in GDP.

The roles of government bodies that determine national fiscal policies

The government plays an important role in establishing fiscal policies in the economy. The components of fiscal policy include government expenditure and taxation which are always regulated depending on whether the motive is contractionary or expansionary. However, the government doe not do this in isolation; rather it does so through various government bodies including Federal Reserve and the Internal Revenue Service to handle government expenditure and taxation respectively.

Generally, the Federal Reserve regulates the supply of money in the economy as well as adjusting interest rates depending on the state of the business cycle. Conversely, the IRS plays the role of collecting taxes as well as enforcing tax laws established by the government. For instance, when fiscal policies involve addressing the issue of recession, the Federal Reserve prints more money and lowers interest rates to encourage spending or ignite the aggregate demand, while the IRS will enforce the government’s policy to cut down taxes.

Explain the effects of fiscal policies on the economy’s production and employment. How do changes in government spending and taxes positively or negatively affect the economy’s production and employment?

Fiscal policies have a direct effect on aggregate demand in the economy which is a stimulus to the level of production and employment. When the economy is experiencing a recession, fiscal policies tend to create an environment where consumers can increase their spending through measures such as increasing money supply and cutting taxes and in the process enable firms to increase investment. The result will be increased production and employment.

Government spending and taxation may have both positive and negative effects depending on how they are implemented. For instance, government spending provides increases aggregate demand leading to high production and a move towards full employment. However, when the government spending is prolonged and causes interest rates to rise, it may lead to a crowding-out effect thus reducing investments and affecting production.

On the other hand, tax cuts tend to provide incentives to the consumers to spend more and the firms to raise production and increase employment. However, tax cuts may create a huge budget deficit that may become counterproductive in the long run.


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