© 2005 Thomson C hapter 23 Fiscal Policy: Coping with Inflation and Unemployment.

© 2005 Thomson

CChapter 23hapter 23

Fiscal Policy: Coping Fiscal Policy: Coping with Inflation and with Inflation and

UnemploymentUnemployment

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Frictional, structural, and cyclical unemployment

Discouraged and underemployed workers

The natural rate of unemployment

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Economic PrinciplesEconomic Principles

Winners and losers from inflation

Recessionary and inflationary gaps

The tax multiplier

The balanced budget multiplier

Fiscal policy options

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Fiscal PolicyFiscal Policy

Recall that the national economy, if not already in equilibrium, is always moving toward it. But is equilibrium particularly attractive?

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Equilibrium tells us nothing about satisfaction or the general state of the economy.

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For example, the economy can be in equilibrium and at the same time still be unable to provide employment to those wanting jobs.

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Equilibrium and Full Equilibrium and Full EmploymentEmployment

In order to define full employment, we need to look at the reasons why people may not have jobs.

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Frictional unemployment

• Relatively brief periods of unemployment caused by people deciding to voluntarily quit work in order to seek more attractive employment.

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Frictional unemployment

• Initial job hunting or job switching for improvement is seldom smooth or instantaneous, but quite natural in a dynamic economy.

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Structural unemployment

• Unemployment that results from fundamental technological changes in production, or from the substitution of new goods for customary ones.

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The impact of structural unemployment falls particularly hard on older workers. They are the ones that acquired years of on-the-job experience to match a specific technology. It is difficult for them to start over again.

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If people are to enjoy the benefits that advanced technology affords, then the pain of structural unemployment has to be paid.

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Cyclical unemployment

• Unemployment associated with the downturn and recession phases of the business cycle.

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Discouraged workers

• Unemployed people who give up looking for work after experiencing persistent rejection in their attempts to find work.

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Many discouraged workers end up in a nonwork culture and remain permanently separated from the productive society.

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Underemployed workers

• Workers employed in jobs that do not utilize their productive talents or experience.

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In periods of recession, the number of people who end up as discouraged workers or among the underemployed workers can be rather significant.

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The unemployment rate for an economy depends on decisions about who belongs in the unemployment pool.

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EXHIBIT 1 NUMBER OF WORKERS AND TYPES OF UNEMPLOYMENT

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Exhibit 1: Number of Exhibit 1: Number of Workers and Types of Workers and Types of

UnemploymentUnemployment1. What is the unemployment rate in Exhibit 1 if only people affected by frictional, structural, and cyclical unemployment are considered “unemployed?”• Unemployment rate = [(150 + 200 + 500) /10,250] × 100 = 8.3 percent.

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Exhibit 1: Number of Exhibit 1: Number of Workers and Types of Workers and Types of

UnemploymentUnemployment2. What is the unemployment rate if discouraged workers and underemployed workers are also considered “unemployed?”• Unemployment rate = [(150 + 200 + 500 + 250 + 300)/10,250] × 100 = 13.7 percent.

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The Bureau of Labor Statistics (BLS) of the U.S. Labor Department conducts a monthly, nationwide employment survey of 60,000 households.

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The critical questions asked is:

Are you presently gainfully employed or actively seeking employment?

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Labor force

• People who are gainfully employed or actively seeking employment.

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People who are neither gainfully employed nor looking for work, such as children, retirees, students, and the institutionalized, are neither unemployed nor a part of the labor force, according to the BLS.

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• Underemployed workers, according to the BLS, are counted as employed and part of the labor force.

• Discouraged workers are not considered unemployed, because they are not actively seeking employment.

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Natural rate of unemployment

• The rate of unemployment caused by frictional plus structural unemployment in the economy.

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Full employment

• An employment level at which the actual rate of unemployment in the economy is equal to the economy’s natural rate of unemployment.

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The economy is considered to be at full employment when the rate of cyclical unemployment is zero.

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Recall the three segments of the aggregate supply curve. The first segment is horizontal—real GDP can increase without an increase in the price level because there is a ready pool of unemployed workers to draw upon at current wage rates.

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The second segment is upward sloping. Real GDP increases, but only if producers offer higher wage rates to induce more people into the labor force. The price level rises.

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The third segment is vertical. Everyone who is capable of working at any wage rate is working. No further increases in the price level can generate more real GDP. If the aggregate demand curve shifts upward, real GDP remains the same but the price level increases.

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EXHIBIT 2 THE FULL-EMPLOYMENT LEVEL OF THE AGGREGATE SUPPLY CURVE AND THE EFFECTS OF AN INCREASE IN AGGREGATE DEMAND

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Exhibit 2: The Full-Exhibit 2: The Full-Employment Level of the Employment Level of the Aggregate Supply Curve Aggregate Supply Curve

and the Effects of an and the Effects of an Increase in Aggregate Increase in Aggregate

DemandDemand1. At what level of real GDP is full employment realized in Exhibit 2?

• Full employment is realized when real GDP equals $1,200 billion.

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Exhibit 2: The Full-Exhibit 2: The Full-Employment Level of the Employment Level of the Aggregate Supply Curve Aggregate Supply Curve

and the Effects of an and the Effects of an Increase in Aggregate Increase in Aggregate

DemandDemand2. What happens to the price level when aggregate demand shifts from AD1 to AD2 in panel b?

• The price level increases from P = 110 to P = 120.

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Understanding Understanding InflationInflation

Inflation redistributes income. Some people win and some people lose from the redistribution.

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Perhaps more than any other group, people living on fixed incomes have reason to worry about inflation. Losers may also include landlords whose incomes are tied to long-term rental leases and workers who accepted union-negotiated, multiyear, fixed-wage contracts.

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People who borrow money end up winners under inflation if the interest rate a borrower pays on the borrowed funds is less than the rate of inflation.

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For example, suppose you borrowed $100 at 5 percent interest to buy a pair of shoes. At the end of the loan period, you repay the bank $105. Had you waited until this year to buy the shoes, with inflation at 10 percent, it would have cost you $110.

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The government, as the largest single borrower, benefits from inflation. Inflation, with time, reduces the real cost to government of carrying the national debt. In addition, inflation may bump more citizens into higher tax brackets, resulting in higher income taxes paid to the government.

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Inflationary risks are shifted when banks tie mortgage rates to the rate of inflation, union contracts include provisions for a cost-of-living adjustment (COLA) tied to inflation, and when the federal government adjusts income tax brackets based on inflation.

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Living in a World of Living in a World of Inflation and Inflation and

UnemploymentUnemploymentRecall that national income equilibrium may not occur at full employment. In such an equilibrium, some unemployed people may fail to find employment, no matter how hard they try.

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UnemploymentUnemploymentRecessionary gap

• The amount by which aggregate expenditure falls short of the level needed to generate equilibrium national income at full employment without inflation.

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UnemploymentUnemploymentInflationary gap

• The amount by which aggregate expenditure exceeds the aggregate expenditure level needed to generate equilibrium national income at full employment without inflation.

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UnemploymentUnemploymentThe amount by which aggregate expenditure needs to increase or decrease depends primarily on the marginal propensity to consume.

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EXHIBIT 3A RECESSIONARY AND INFLATIONARY GAPS

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EXHIBIT 3B RECESSIONARY AND INFLATIONARY GAPS

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Exhibit 3: Recessionary Exhibit 3: Recessionary and Inflationary Gapsand Inflationary Gaps

What two points define the recessionary gap in panel a of Exhibit 3? • The recessionary gap is defined by points hg.

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Closing Recessionary Closing Recessionary and Inflationary Gapsand Inflationary Gaps

When an economy is at equilibrium, there is no justification for producers to increase investment spending—even if it would reduce unemployment.

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Government, however, can design public investment projects to close the recessionary gap. Super-highways, public housing, space programs and defense are all projects that could be initiated to absorb the investment funds.

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There are problems with closing a recessionary gap, however. First, once the funds are invested, they tend to continue to be invested year after year—whether or not they are needed to close a recessionary gap.

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Second, some economists believe that the advocates of government intervention fail to appreciate the self-correcting nature of the economy.

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The inflationary gap can also be closed. Private sector investment and government funding can both be cut to close the gap.

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Making Fiscal PolicyMaking Fiscal Policy

In order to raise funds to close the recessionary gap, the government can either raise taxes or borrow money. The government borrows money by issuing interest-bearing IOUs.

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Fiscal policy

• Government spending and taxation policy to achieve macroeconomic goals of full employment without inflation.

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Balanced budget

• Government spending equals tax revenue. The equation is written:

G = T,

Where G = government spending and T = tax revenue.

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Making Fiscal PolicyMaking Fiscal PolicyIn order to come up with the money to pay increased income taxes, people must consume less and save more. Their reduced consumption spending does not cancel out the positive effect of the increased government spending, however.

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Tax multiplier

• The multiple by which the equilibrium level of national income changes when a dollar change in taxes occurs. The multiple depends upon the marginal propensity to consume.

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Like the income multiplier, the tax multiplier magnifies the effect of taxes on the level of national income. But income magnification from taxes is the weaker of the two.

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The reason why the tax multiplier is weaker is because not all of the income required to pay the tax comes from people’s consumption spending. Part comes from would-be savings.

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Making Fiscal PolicyMaking Fiscal PolicyFor example, suppose the government imposes a 20 percent income tax. An individual earning $50,000 per year would owe $10,000. If MPC = 0.80, then $8,000 of the tax will be cut from consumption spending and $2,000 of the tax will come from would-be savings.

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The tax multiplying factor, when MPC = 0.80, is:

-0.80/(1 - 0.80) = -4.

The $10,000 tax generates a $40,000 decline in national income.

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Making Fiscal PolicyMaking Fiscal PolicyGovernment doesn’t save. It takes the $10,000 generated through taxes and spends the entire amount. The income multiplier is:

1/(1 - 0.80) = 5.

The increase in national income generated by the $10,000 tax is $50,000.

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Balanced budget multiplier

• The effects on the equilibrium level of national income of an equal change in government spending and taxes. The balanced budget multiplier is 1.

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Exhibit 4: Sample Budget Exhibit 4: Sample Budget Options to Close a Options to Close a

Recessionary Gap ($ Recessionary Gap ($ billions)billions)

What might be a problem with Option 1, the balanced budget option, in Exhibit 4?• The option would require the entire recessionary gap to be made up by income taxes. This option may be politically unpopular.

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Exhibit 4: Sample Budget Exhibit 4: Sample Budget Options to Close a Options to Close a

Recessionary Gap ($ Recessionary Gap ($ billions)billions)

What might be a problem with Option 1, the balanced budget option, in Exhibit 4?• In addition, government becomes a major participant in the national economy. A hot political issue is: How much government is the right amount of government?

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Exhibit 5: Sample Budget Exhibit 5: Sample Budget Options to Close an Options to Close an

Inflationary Gap ($ billions)Inflationary Gap ($ billions)What might be some problems associated with Option 1 in Exhibit 5?• While people would love to see their taxes cut substantially, the associated drastic cut in government spending would be unworkable.

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Exhibit 5: Sample Budget Exhibit 5: Sample Budget Options to Close an Options to Close an

Inflationary Gap ($ billions)Inflationary Gap ($ billions)What might be some problems associated with Option 1 in Exhibit 5?• It would mean too many cuts in necessary public programs such as Medicare, funding for higher education, and highway repair.

© 2005 Thomson C hapter 23 Fiscal Policy: Coping with Inflation and Unemployment.

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