Download Fiscal Policy: Coping with Inflation and Unemployment

Chapter 23
Fiscal Policy: Coping with
Inflation and Unemployment
© 2005 Thomson
Economic Principles
Frictional, structural, and cyclical
unemployment
Discouraged and underemployed
workers
The natural rate of unemployment
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Economic 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 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
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 onthe-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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EXHIBIT 1
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
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 union-negotiated, 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
self-correcting 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 wouldbe 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
$50,000.
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Making Fiscal Policy
Balanced budget multiplier
• The effects on the equilibrium level of
national income of an equal change in
government spending and taxes. The
balanced budget multiplier is 1.
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Making Fiscal Policy
Budget deficit
• Government spending exceeds tax
revenues.
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EXHIBIT 4
SAMPLE BUDGET OPTIONS TO CLOSE A
RECESSIONARY GAP ($ BILLIONS)
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Exhibit 4: Sample Budget Options to
Close a Recessionary Gap ($ 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 Options to
Close a Recessionary Gap ($ 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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Making Fiscal Policy
Budget surplus
• Tax revenues exceed government spending.
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EXHIBIT 5
SAMPLE BUDGET OPTIONS TO CLOSE AN
INFLATIONARY GAP ($ BILLIONS)
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Exhibit 5: Sample Budget Options to
Close an 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 Options to
Close an 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.
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