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Chapter 23
Fiscal Policy: Coping with
Inflation and Unemployment
© 2002 South-Western
Economic Principles
• Frictional, structural, and
cyclical unemployment
• Discouraged and underemployed
workers
• The natural rate of
unemployment
2
Economic Principles
• Winners and losers from
inflation
• Recessionary and inflationary
gaps
• The tax multiplier
• The balanced budget multiplier
3
Economic Principles
• Fiscal policy options
4
Fiscal Policy
Recall that the national economy,
if not already in equilibrium, is
always moving toward it. But is
equilibrium particularly
attractive?
5
Fiscal Policy
Equilibrium tells us nothing about
satisfaction or the general state of
the economy.
6
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.
7
Equilibrium and Full
Employment
In order to define full
employment, we need to look at
the reasons why people may not
have jobs.
8
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.
9
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.
10
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.
11
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.
12
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.
13
Equilibrium and Full
Employment
Cyclical unemployment
Unemployment associated with
the downturn and recession
phases of the business cycle.
14
Equilibrium and Full
Employment
Discouraged workers
Unemployed people who give up
looking for work after
experiencing persistent rejection
in their attempts to find work.
15
Equilibrium and Full
Employment
Many discouraged workers end
up in a nonwork culture and
remain permanently separated
from the productive society.
16
Equilibrium and Full
Employment
Underemployed workers
Workers employed in jobs that do
not utilize their productive talents
or experience.
17
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.
18
Equilibrium and Full
Employment
The unemployment rate for an
economy depends on decisions
about who belongs in the
unemployment pool.
19
EXHIBIT 1
NUMBER OF WORKERS AND TYPES OF
UNEMPLOYMENT
20
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.
21
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.
22
Equilibrium and Full
Employment
The Bureau of Labor Statistics (BLS)
of the US Labor Department conducts
a monthly, nationwide employment
survey of 60,000 households.
23
Equilibrium and Full
Employment
The critical questions asked is:
Are you presently gainfully employed
or actively seeking employment?
24
Equilibrium and Full
Employment
Labor force
People who are gainfully employed or
actively seeking employment.
25
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.
26
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.
27
Equilibrium and Full
Employment
Natural rate of unemployment
The rate of unemployment caused by
frictional plus structural
unemployment in the economy.
28
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.
29
Equilibrium and Full
Employment
The economy is considered to be at
full employment when the rate of
cyclical unemployment is zero.
30
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.
31
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.
32
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.
33
EXHIBIT 2
THE FULL-EMPLOYMENT LEVEL OF THE
AGGREGATE SUPPLY CURVE AND THE
EFFECTS OF AN INCREASE IN AGGREGATE
DEMAND
34
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.
35
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.
36
Understanding Inflation
Inflation redistributes income.
Some people win and some people
lose from the redistribution.
37
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.
38
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.
39
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.
40
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.
41
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.
42
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.
43
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.
44
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.
45
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.
46
EXHIBIT 3A RECESSIONARY AND INFLATIONARY GAPS
47
EXHIBIT 3B RECESSIONARY AND INFLATIONARY GAPS
48
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.
49
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.
50
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.
51
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.
52
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.
53
Closing Recessionary and
Inflationary Gaps
Third, the funds must come from
somewhere. Debt financing places
burdens on the future economy.
54
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.
55
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.
56
Making Fiscal Policy
Fiscal policy
Government spending and
taxation policy to achieve
macroeconomic goals of full
employment without inflation.
57
Making Fiscal Policy
Balanced budget
Government spending equals tax
revenue. The equation is written:
G = T,
Where G = government spending
and T = tax revenue.
58
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.
59
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.
60
Making Fiscal Policy
Tax multiplier
The equation for the tax
multiplier is:
-MPC / (1 - MPC).
61
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.
62
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.
63
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.
64
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.
65
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
$50,000.
66
Making Fiscal Policy
Balanced budget multiplier
The effects on the equilibrium
level of national income of an
equal change in government
spending and taxes. The balanced
budget multiplier is 1.
67
Making Fiscal Policy
Budget deficit
Government spending exceeds tax
revenues.
68
EXHIBIT 4
SAMPLE BUDGET OPTIONS TO CLOSE A
RECESSIONARY GAP ($ BILLIONS)
69
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.
70
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?
71
Making Fiscal Policy
Budget surplus
Tax revenues exceed government
spending.
72
EXHIBIT 5
SAMPLE BUDGET OPTIONS TO CLOSE AN
INFLATIONARY GAP ($ BILLIONS)
73
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.
74
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.
75