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Chapter 23
FISCAL POLICY: COPING
WITH INFLATION AND
UNEMPLOYMENT
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Economic Principles
Frictional, structural, and cyclical
unemployment
Discouraged and underemployed
workers
The natural rate of unemployment
Winners and losers from inflation
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Economic Principles
Recessionary and inflationary gaps
The tax multiplier
The balanced budget multiplier
Fiscal policy options
The business cycle
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Fiscal 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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Fiscal Policy
When the economy is in equilibrium,
it can sometimes be distressful.
Equilibrium tells us nothing about
satisfaction or the general state of
the economy.
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Fiscal Policy
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 Employment
In order to define full employment, we
need to look at the reasons why
people may not have jobs.
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Equilibrium and Full Employment
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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Equilibrium and Full Employment
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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Equilibrium and Full Employment
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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Equilibrium and Full Employment
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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Equilibrium and Full Employment
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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Equilibrium and Full Employment
Cyclical unemployment
• Unemployment associated with the downturn
and recession phases of the business cycle.
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Equilibrium and Full Employment
Discouraged workers
• Unemployed people who give up looking for
work after experiencing persistent rejection
in their attempts to find work.
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Equilibrium and Full Employment
Many discouraged workers end up in
a nonwork culture and remain
permanently separated from the
productive society.
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Equilibrium and Full Employment
Underemployed workers
• Workers employed in jobs that do not utilize
their productive talents or experience.
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Equilibrium and Full Employment
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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Equilibrium and Full Employment
The unemployment rate for an economy
depends on decisions about who
belongs in the unemployment pool.
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Counterfeit Unemployment
Not everybody who’s unemployed is
really unemployed.
• There are people who opt out of employment
using any number of excuses.
• There are those who cannot hold on to a job.
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EXHIBIT 1
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NUMBER OF WORKERS AND TYPES OF
UNEMPLOYMENT
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Exhibit 1: Number of Workers
and Types of Unemployment
1. 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 Workers
and Types of Unemployment
2. 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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Equilibrium and Full Employment
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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Equilibrium and Full Employment
The critical questions asked is:
Are you presently gainfully employed or
actively seeking employment?
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Equilibrium and Full Employment
Labor force
• People who are gainfully employed or
actively seeking employment.
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Equilibrium and Full Employment
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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Equilibrium and Full Employment
• 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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Equilibrium and Full Employment
Natural rate of unemployment
• The rate of unemployment caused by
frictional plus structural unemployment in
the economy.
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Equilibrium and Full Employment
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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Equilibrium and Full Employment
The economy is considered to be at
full employment when the rate of
cyclical unemployment is zero.
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Equilibrium and Full Employment
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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Equilibrium and Full Employment
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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Equilibrium and Full
Employment
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
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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-Employment Level
of the Aggregate Supply Curve and
the Effects of an Increase in
Aggregate Demand
1. 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-Employment Level
of the Aggregate Supply Curve and
the Effects of an Increase in
Aggregate Demand
2. 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 Inflation
Inflation redistributes income. Some
people win and some people lose
from the redistribution.
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Understanding Inflation
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 unionnegotiated, multiyear, fixed-wage
contracts.
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Understanding Inflation
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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Understanding Inflation
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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Understanding Inflation
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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Understanding Inflation
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 Inflation
and Unemployment
Recall 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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Living in a World of Inflation
and Unemployment
Recessionary 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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Living in a World of Inflation
and Unemployment
Inflationary 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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Living in a World of Inflation
and Unemployment
The 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 and
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 and
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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Closing Recessionary and
Inflationary Gaps
Government, however, can design public
investment projects to close the
recessionary gap. Superhighways,
public housing, space programs and
defense are all projects that could be
initiated to absorb the investment funds.
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Closing Recessionary and
Inflationary Gaps
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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Closing Recessionary and
Inflationary Gaps
Second, some economists believe that
the advocates of government
intervention fail to appreciate the selfcorrecting nature of the economy.
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Closing Recessionary and
Inflationary Gaps
Third, the funds must come from
somewhere. Debt financing places
burdens on the future economy.
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Closing Recessionary and
Inflationary Gaps
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 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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Making Fiscal Policy
Fiscal policy
• Government spending and taxation policy to
achieve macroeconomic goals of full
employment without inflation.
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Making Fiscal Policy
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 Policy
In 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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Making Fiscal Policy
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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Making Fiscal Policy
Tax multiplier
• The equation for the tax multiplier is:
–MPC/(1 – MPC)
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Making Fiscal Policy
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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Making Fiscal Policy
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 Policy
For 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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Making Fiscal Policy
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 Policy
Government 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
$50,000.
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Making Fiscal Policy
Balanced budget multiplier
• The effects on the equilibrium level of national
income of an equal change in government
spending and taxes. The balanced budget
multiplier is 1.
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Making Fiscal Policy
Budget deficit
• Government spending exceeds tax revenues.
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EXHIBIT 4
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SAMPLE BUDGET OPTIONS TO CLOSE A
RECESSIONARY GAP ($ BILLIONS)
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Exhibit 4: Sample Budget Options to
Close a Recessionary Gap
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 Options to
Close a Recessionary Gap
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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Making Fiscal Policy
Budget surplus
• Tax revenues exceed government spending.
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EXHIBIT 5
© 2013 Cengage Learning
SAMPLE BUDGET OPTIONS TO CLOSE AN
INFLATIONARY GAP ($ billions)
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Exhibit 5: Sample Budget Options to
Close an Inflationary Gap
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 Options to
Close an Inflationary Gap
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.
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Countercyclical Fiscal Policy
Why is locking on a stationary target
of national income equilibrium seem
pointless?
• Because the economy’s performance itself is
always in a constant state of motion.
• The economy’s deviations trace a series of
recurring cycles, with years of rapid
economic growth followed by economic
decline.
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Countercyclical Fiscal Policy
Countercyclical fiscal policy
• Fiscal policy designed to moderate the
severity of the business cycle by introducing
ever-changing fiscal policy prescriptions in
order to temper the always recurring cycles.
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The Business Cycle
The business cycle represents year to
year deviations from the dominant,
long-run path of U.S. economic growth.
These deviations seem to map out a
picture of recurring cycles.
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The Business Cycle
What causes cycles in the first place?
• External, random events, such as wars,
population booms, housing starts, clustering
of innovations, and tech-stock or credit
bubbles.
• Other cycles are internal, that is, selfgenerating by and within the economy.
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EXHIBIT 7 THE U.S. BUSINESS CYCLE RECORD:
1860–2003
The year-to-year change in GDP is depicted as percentage deviations from the long-term trend growth rate. Sharp upturns are clearly
marked by the Civil War, World War II, the Korean War, and the Vietnam War. The Great Depression of the 1930s and the sharp economic
recovery following World War II dominate the picture.
Source: Ameritrust Company, Cleveland, Ohio and Economic Report, The President, 2006.
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Exhibit 7: The U.S. Business
Cycle Record: 1860–2003
1. According to Exhibit 7, were
recessions more frequent before
World War II or after World War II?
• Recessions were more frequent before World
War II.
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Exhibit 7: The U.S. Business
Cycle Record: 1860–1990
2. In which of the following decades
was there the greatest period of
rapid and prolonged economic
growth in Exhibit 7?
a. 1870–1880
b. 1930–1940
c. 1960–1970
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Exhibit 7: The U.S. Business
Cycle Record: 1860–1990
2. In which of the following decades
was there the greatest period of
rapid and prolonged economic
growth in Exhibit 7?
a. 1870–1880
b. 1930–1940
c. 1960–1970
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Bubbles and Cycles
How does a bubble form?
• When many investors invest in new technology,
innovation, product, and the like based on the
excitement it elicits in the market.
• The result is skyrocketing product and stock
prices even when totally at variance with market
fundamentals.
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Bubbles and Cycles
How do bubbles burst?
• When excitement and market expectation
dampen, investors get out of the market in the
belief that their investment will lose value.
• That thinking alone brings on the expected
collapse.
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Multiplier and Accelerator Cycle
The interaction of the multiplier and
accelerator alone can induce cycles.
• This interaction causes changes in investment
and in national income that become mutually
reinforcing.
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Multiplier and Accelerator Cycle
A change in investment generates, via
the multiplier, a change in national
income that induces, via the
accelerator, a higher level of
investment that generates, via the
multiplier, yet another change in
national income, and so on.
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Multiplier and Accelerator Cycle
Accelerator
• The relationship between the level of
investment and the change in the level of
national income.
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Real Business Cycle Theory
Economists who subscribe to real
business cycle theory challenge the
idea that internal or external cycles
exist.
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Real Business Cycle Theory
They argue that the economy is
dynamic and operates near full
employment. The principal factor
shaping the unevenness (not cycles)
in the economy’s growth path is the
random occurrence of many small
productivity-enhancing innovations.
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