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Chapter 23 Fiscal Policy: Coping with Inflation and Unemployment Fred Gottheil 5/23/2017 ©1999 South-Western College Publishing 1 What is a Fiscal Policy? Government spending and taxation to achieve full employment without inflation ©1999 South-Western College Publishing 2 What is the difference between discretionary and nondiscretionary fiscal policy? Discretionary, newly enacted legislation changing G and T to affect the economy Nondiscretionary, automatic stabilizers-automatic changes in G and T as the economy changes. 3 Who is unemployed? Anyone who is at least 16 years of age and is actively seeking employment ©1999 South-Western College Publishing 4 Who makes up the Labor Force? All non-institutionalized people 16 years of age and older who are either working or actively looking for work ©1999 South-Western College Publishing 5 What is the Unemployment rate? • The number of unemployed people expressed as a percentage of the labor force • U rate = U/ U + E, where U= unemployed, and E= employed ©1999 South-Western College Publishing 6 How do we measure unemployment? The number of unemployed divided by the labor force, U rate = U/ U + E 7 Breakdown of the US Population and the Labor Force Persons under 16 Persons in the armed forces Persons institutionalized Total Population Not in Labor Force Civilian Noninstitutional Population Employed Civilian Labor Force Unemployed Who measures unemployment? The Bureau of Labor Statistics surveys about 60,000 households each month ©1999 South-Western College Publishing 9 For current data on unemployment: http://stats.bls.gov/eag.table.html http://stats.bls.gov/cpshome.htm ©1999 South-Western College Publishing 10 What are some of the problems in measuring unemployment? • Discouraged worker problem • Part time workers • Dishonest workers 11 Who is a Discouraged Worker? A person who drops out of the work force because he or she cannot find a job ©1999 South-Western College Publishing 12 Are Discouraged Workers counted in the labor force? No! People who have quit looking for work are not counted as part of the labor force ©1999 South-Western College Publishing 13 What about parttime workers? Part time workers are counted as fully employed 14 What about people who are over-qualified for their jobs? They are still considered fully employed ©1999 South-Western College Publishing 15 What’s a dishonest worker? Someone who claims to be looking for work but really is not 16 Is the unemployment rate valid? Yes! As long as we are consistent, we can get an accurate comparison from one time period to the next ©1999 South-Western College Publishing 17 Can the unemployment rate increase without anyone losing a job? If more people enter the work force than the number of new jobs generated, the unemployment rate increases ©1999 South-Western College Publishing 18 What are different types of unemployment? • Frictional • Structural • Cyclical • Seasonal ©1999 South-Western College Publishing 19 What is frictional unemployment? Unemployment due to normal turnover of the labor force, new entrants to the labor force, reentrants, job leavers 20 What is structural unemployment? Unemployment due to structural changes such as new technologies leading to declines in demand for some jobs 21 What is cyclical unemployment? Unemployment due to a recession, or downturn in the economy 22 What is the natural rate of unemployment? The sum of frictional and structural unemployment 23 What is considered Full Employment? An employment level at which the actual rate of unemployment is equal to the natural rate of unemployment ©1999 South-Western College Publishing 24 What is considered to be the natural rate of unemployment? The natural rate varies, most estimates are from 4-6% ©1999 South-Western College Publishing 25 Have more women entered the work force? Since the 1950’s there has been a large increase in the number of women in the work force ©1999 South-Western College Publishing 26 What percentage of the work force today is female? Almost half 27 What was the unemployment rate during the worst of the Great Depression? In 1933, 25% of the labor force was unemployed ©1999 South-Western College Publishing 28 Why should we care about unemployment? Economic costs, lost output and income Social costs 29 Are there any benefits of unemployment? Allocative benefits Disciplinary benefits 30 What is Inflation? The general upward movement in the average level of prices ©1999 South-Western College Publishing 31 What is Deflation? The general decrease in the average level of prices ©1999 South-Western College Publishing 32 What is the Consumer Price Index (CPI)? A measure of the cost of a fixed “market basket” of consumer goods and services ©1999 South-Western College Publishing 33 How is the CPI calculated? CPI = Value of the market basket in the current period Value of the market basket in the base period 34 If the value of the CPI equals 120, what does this mean? The fixed market basket of goods costs 20% more than in the base period of time 35 Does the makeup of the CPI change? As people’s tastes and preferences change, what goes into the basket will change ©1999 South-Western College Publishing 36 Who measures inflation? The Bureau of Labor Statistics ©1999 South-Western College Publishing 37 For current data on inflation: http://stats.bls.gov/cpshome.htm ©1999 South-Western College Publishing 38 Problems with the CPI • Substitution bias • Changes in quality of goods • Use of retail prices 39 What are the effects of unexpected inflation? Inflation redistributes income, some people win, some lose 40 Who wins and who loses from inflation? Debtors win, creditors lose Real interest rate = Nominal rate -expected inflation 41 More winners and losers of inflation • • • • • • Those on fixed incomes lose Savers often lose Government sometimes wins Menu costs of inflation Inflation psychology develops Inflation and uncertainty 42 What is a Recessionary Gap? The amount by which aggregate expenditure falls short of a full employment equilibrium, thus giving high unemploymentassume little inflation however ©1999 South-Western College Publishing 43 Aggregate Expenditure The Recessionary Gap C2+I2+G2+(x-m)2 C1+I1+G1+(x-m)1 less than full employment full employment 45o Y1 Yf Real GDP (income) 44 44 Fiscal policy to help solve a recessionary gap • Raise government spending • Lower taxes • Attempting to expand or stimulate the economy • Remember, multiplier effects 45 Aggregate Expenditure The Recessionary Gap C2+I2+G2+(x-m)2 C1+I1+G1+(x-m)1 less than full employment full employment 45o Y1 Yf Real GDP (income) 46 46 What is an Inflationary Gap? The amount by which aggregate expenditure exceeds the full employment equilibrium, thus a booming economy, leading to demand pull inflation. ©1999 South-Western College Publishing 47 Aggregate Expenditure The Inflationary Gap C2+I2+G2+(x-m)2 C1+I1+G1+(x-m)1 full employment New equilibrium 45o Yf Y1 GDP (income) 48 48 Fiscal policy to help solve an inflationary gap • Lower government spending • Raise taxes • Attempting to contract or slow down the economy 49 Aggregate Expenditure The Inflationary Gap C2+I2+G2+(x-m)2 C1+I1+G1+(x-m)1 full employment New equilibrium 45o Yf Y1 GDP (income) 50 50 What is the formula for the tax multiplier? -MPC/MPS 51 Recall the income (expenditure) multiplier of the previous chapter, multiplier = 1/MPS, say government spending increases by 100 billion 52 $100 billion $90 MPC = 9/10 $81 MPS = 1/10 $74 ... $1,000 5 3 53 Now suppose instead of raising G by 100, we cut taxes by 100--will people spend all of the 100 billion? 54 Answer is No, some will be saved--assume again MPC=.9, MPS=.1, thus 90% of tax cut is spent or 90 billion initial change in spending 55 $100 billion $90 MPC = 9/10 $81 MPS = 1/10 $74 ... 1,000 900 5 6 56 Thus since -100 = tax cut, and GDP grew by 900, we have a tax multiplier of -9 Using the tax multiplier, initial change in taxes times the tax multiplier equals the maximum change in GDP 57 Practice with the tax multiplier Tax cut = 5 billion, MPC = .75, what is the maximum ΔGDP? Tax increase = 10 billion, MPS = .4, what is the maximum ΔGDP? Tax cut of 8 billion, MPC = 2/3, what is the maximum ΔGDP? 58 Answers: 1. 15 billion 2. -15 billion 3. 16 billion 59 Why are Fiscal Policies to stem a Recessionary Gap not problem free? • Spending becomes permanent • Ignores the self-correcting nature of the economy • It can be very expensive ©1999 South-Western College Publishing 60 Why are Fiscal Policies to stem an Inflationary Gap not problem free? To cut government spending or raise taxes can be politically unpopular ©1999 South-Western College Publishing 61 Other problems with fiscal policy Time lags: Can we time fiscal policy correctly? 1. Recognition lag, time between a change in the economy and our realizing it 2. Administrative lag, time for congress to act, pass laws, etc. 3. Impact lag, time for policy to actually have its effect, multipliers to work, etc. 62 Time lags could cause 2 problems 1. Miss the boat, problem over before policy gets going 2. Destabilize, rather than stabilize the economy 63 Another possible problem with fiscal policy, crowding out Say Raise G to stimulate economy, borrow the money by selling bonds, could raise interest rates, lead to less investment and consumption--thus the higher G spending “crowds out” private sector spending. 64 Keynesians see little crowding out in recessionary times Could in fact be that increased G spending, if output begins expanding, might raise optimism and increase investment and consumption rather than crowd it out. 65 For information on government spending: http://www.access.gpo.gov/su_docs/ budget/index.html http://www.cato.org http://www.publicdebt.treas.gov http://www.concordcoalition.org ©1999 South-Western College Publishing 66 What is the Balanced Budget Multiplier? When the government increases spending and taxes by equal amount, what will be the combined effect on output, taking both multipliers into account? ©1999 South-Western College Publishing 67 Say both G and T increase by 20 billion, MPC = .8, MPS=.2 G: 20 billion x 1/MPS, gives 20 billion x 5 = 100 billion increase in GDP T: 20 billion x -MPC/MPS gives 20 billion x -4 = -80 billion drop in GDP Total effect, 100 + -80 = 20, the initial change in spending Thus multiplier = 1 68 What does the Balanced Budget Multiplier always equal? ONE ©1999 South-Western College Publishing 69 • Who is unemployed? • Who makes up the labor force? • Can the unemployment rate increase without anyone losing a job? • What is Full Employment? • What is Inflation? 70 •Who loses from Inflation? •Who gains from Inflation? •What is a Recessionary Gap? •What is an Inflationary Gap? •What is a Fiscal Policy? •What is a Balanced Budget? •What is the Balanced Budget Multiplier? 71