Special Problems in Economics Research Paper Starter

Special Problems in Economics

There are myriad factors in economics that can influence fiscal health or anemia. While economists are a constantly evolving breed in search of a relevant mechanism that can help explain economic performance, there are elements that, if unaccounted for, can cause serious problems within the study of economics and, ultimately, for policy. This paper examines a few of these problems in the context of prominent domestic and international economic issues.

Keywords Currency Exchange Rates; Liberalization; Linear Modeling; Market Equilibrium; Substitution

Economics: Special Problems in Economics

Overview

The iconic economist Milton Friedman once offered his thoughts on the causes of the Great Depression of the early 20th century, pointing the finger at the government's policy responses to the economic slowdowns that led to the market collapse in 1929. Somewhat contrary to the precepts being proffered by his peer John Keynes, which called for government involvement and intervention in times of economic crisis, Friedman contended that the Depression was "produced by government mismanagement rather than by any inherent instability of the private economy" (Friedman, 2002, p. 38).

What were the forms of mismanagement to which Friedman was referring? In an op-ed piece written after his passing, colleagues Edward Nelson and Anna Schwartz asserted that Friedman was not suggesting that the government was ill advised to issue any responsive policy to the steadily declining economy. Rather, they wrote, the institutions that were established to prevent such a collapse (namely the Federal Reserve) offered solutions that were contradictory to long-term fiscal health, such as raising discount loan rates at a time when banks around the nation were closing (Nelson & Schwartz, 2007).

Similarly, a well-intentioned effort to reinvigorate the economy by installing a series of trade barriers under the Smoot-Hawley Tariff Act of 1930, thereby protecting domestic industries, caused far more harm by making international trade cost-prohibitive for foreign investors. US imports and exports suffered terribly as world trade declined nearly 66 percent over a four-year period (US Department of State, 2007).

Although some loyalists to Keynes assume that Friedman meant that government should have stayed out of formulating policy to counter the market instability of the 1920s and 1930s, in truth he was commenting on the apparent missteps of the government, not on the fact that it had intervened at all. The Depression was to many a "perfect storm": a variety of factors, both in the market and on the part of the government, combined to create a painful, dark period in international history. A large collection of unanticipated factors and conditions joined together to cause the greatest market collapse in US history, and with no control over those elements and no effective policy response on the part of the government, the Depression would take root for years.

The fact that the Fed response created more harm than good, as did Smoot-Hawley, illustrates an important point: there are myriad factors in economics that can influence fiscal health or anemia. While economists are a constantly evolving breed, in search of a relevant mechanism that can help explain economic performance, there are elements that, if unaccounted for, can cause serious problems within the study of economics and, ultimately, for policy. This paper will examine a few of these problems in the context of prominent domestic and international economic issues.

Exchanging Currencies

On September 20, 2007, an extraordinary event occurred. For the first time in over 30 years, the Canadian dollar became equal in value to the US dollar. For decades, it was considered bad fiscal policy for Canadians to take their business to their neighbor to the south, given the great disparity between the two currencies' values. Conversely, during those three decades, the US thrived on the currency gap. Americans, taking advantage of "fire sale" business deals, traveled north in droves to do business, so much so that Fortune published an article titled "Is Canada for Sale?"

When parity was announced, however, a new way of life was born. Canadians began reversing the tide, flowing south to find fire sales of their own. A 1998 Canadian law prohibits banks in that country from merging. In light of this restriction, banks had no choice but to pursue mergers with American financial institutions, moves that would almost always work to the advantage of the US party. With the development of September 2007, however, Toronto-based Dominion Bank announced its acquisition of New Jersey–based Commerce Bankcorp for $8.5 billion — saving $1 billion Canadian, since the deal was first pursued in June of 2007 (Leonard, 2007).

The flip-flop between US and Canadian dollar exchange rates was unanticipated by most, particularly in light of the long-standing inequity between the two. In fact, currency exchange is one of the most difficult areas to model and predict in the field of macroeconomics. Some modeling can be employed to analyze specifically tailored samples of currency relationships in their current states, but such data becomes less reliable when external macroeconomic variables come into the picture and as the perspective moves from the present to the future. Among the variables that can wreak havoc on currency-exchange modeling are industrial shifts, political instabilities, and countless elements that constitute and affect aggregate supply and aggregate demand. One study looks at the propensity for macroeconomic studies to seek simplicity in modeling currency exchange and concludes that overly simplistic modeling may prove inadequate. As an alternative, the authors propose employing mixed models, the foci of which take into account the variety of influences that may impact expectations formation (Uctum, 2007).

The problem that exists with regard to currency exchange is not analysis of the trends and rates at which one currency performs against another. Empirical data can paint a picture of such situations with relative accuracy. It is the forecasting of and long-term expectations for currencies that create inconsistencies and unpredictability in modeling. Linear modeling has been many economists' preferred method of analyzing currency, but the limitations on the degree to which forecasting can be done are indicative of the need for more reliable data-collection resources. One study concludes that other forms of models, such as nonlinear formulae, yield similar results to linear forecasts and, as they rely on forecast data and environmental conditions, may prove more reliable in data collection than their linear counterparts (Boero, 2002).

Market Instability

Arguably, the most difficult challenge facing an economy is not developing industries or maintaining a stable workforce, although these are indeed challenges in and of themselves; it is ensuring that the delicate balancing act between supply and demand, known as equilibrium, continues for the long term. In a free-market system, in which the myriad elements that constitute aggregate supply and demand interact, it is critical that extraneous forces do not cause a disproportionate impact on that balance, lest the market be placed at risk.

Of course, there are a plethora of these external influences, each of which can either have an immediate influence on market stability or set in motion a chain of events that will undermine a market's performance in the long term. While identifying these factors it is not necessarily difficult, predicting when and how they will impact the market is.

The implications of market instability are obvious. In the 1970s, when developing economies were already in a fragile state, a sudden spike in oil prices sent currencies into a freefall and markets all over the world into turmoil (Bleaney, 2005). Market crises such as the Mexican peso collapse of 1994, the Asian economic crisis of...

(The entire section is 3532 words.)