Fiscal Policy

(1)

C

hapter 23

Fiscal Policy: Coping

with Inflation and

Unemployment

(2)

Economic Principles

Frictional, structural, and cyclical unemployment

Discouraged and underemployed workers

(3)

Economic Principles

Winners and losers from inflation Recessionary and inflationary gaps The tax multiplier

(4)

Recall that the national economy, if not already in equilibrium, is

always moving toward it. But is equilibrium particularly

(5)

Fiscal Policy

(6)

Fiscal Policy

For example, the economy can be in equilibrium and at the same

(7)

Equilibrium and Full

Employment

(8)

Employment

Frictional unemployment

•_{Relatively brief periods of unemployment}

(9)

Equilibrium and Full

Employment

Frictional unemployment

•_{Initial job hunting or job switching for}

(10)

Equilibrium and Full

Employment

Structural unemployment

•_{Unemployment that results from}

(11)

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

(12)

Equilibrium and Full

Employment

If people are to enjoy the benefits that advanced technology affords, then the pain of structural

(13)

Equilibrium and Full

Employment

Cyclical unemployment

•_{Unemployment associated with the}

(14)

Equilibrium and Full

Employment

Discouraged workers

•_{Unemployed people who give up looking}

(15)

Equilibrium and Full

Employment

Many discouraged workers end up in a nonwork culture and

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Equilibrium and Full

Employment

Underemployed workers

•_{Workers employed in jobs that do not}

(17)

Equilibrium and Full

Employment

In periods of recession, the

(18)

Equilibrium and Full

Employment

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

(19)

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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) /}

(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}

(22)

Equilibrium and Full

Employment

The Bureau of Labor Statistics

(BLS) of the U.S. Labor Department conducts a monthly, nationwide

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Equilibrium and Full

Employment

The critical questions asked is:

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Equilibrium and Full

Employment

Labor force

•_{People who are gainfully employed or}

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Equilibrium and Full

Employment

People who are neither gainfully employed nor looking for work,

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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}

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Equilibrium and Full

Employment

Natural rate of unemployment

•_{The rate of unemployment caused by}

(28)

Equilibrium and Full

Employment

Full employment

•_{An employment level at which the actual}

(29)

Equilibrium and Full

Employment

(30)

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

(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

(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

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EXHIBIT 2 THE FULL-EMPLOYMENT LEVEL OF THE AGGREGATE SUPPLY CURVE AND THE

(34)

Exhibit 2: The 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

Demand Demand

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

•_{Full employment is realized when real}

(35)

Exhibit 2: The 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

Demand 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}

(36)

Understanding

Inflation

Inflation redistributes income.

(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

(38)

Understanding

Inflation

People who borrow money end up winners under inflation if the

(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

(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

(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

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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

(43)

Living in a World of

Inflation and

Unemployment

Recessionary gap

•_{The amount by which aggregate}

(44)

Living in a World of

Inflation and

Unemployment

Inflationary gap

•_{The amount by which aggregate}

(45)

Living in a World of

Inflation and

Unemployment

The amount by which aggregate expenditure needs to increase or

(46)

(47)

(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}

(49)

Closing Recessionary

When an economy is at equilibrium, there is no justification for

(50)

Closing Recessionary

Government, however, can design public investment projects to close the recessionary gap.

Super-highways, public housing, space programs and defense are all

(51)

Closing Recessionary

There are problems with closing a recessionary gap, however. First, once the funds are invested, they

(52)

Closing Recessionary

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

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Closing Recessionary

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Making Fiscal Policy

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Fiscal policy

•_{Government spending and taxation policy}

(57)

Making Fiscal Policy

Balanced budget

•_{Government spending equals tax revenue.}

The equation is written:

G = T,

(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

(59)

Making Fiscal Policy

Tax multiplier

•_{The multiple by which the equilibrium}

level of national income changes when a

(60)

Making Fiscal Policy

Tax multiplier

•_{The equation for the tax multiplier is:}

(61)

Making Fiscal Policy

Like the income multiplier, the tax multiplier magnifies the effect of

taxes on the level of national

(62)

Making Fiscal Policy

The reason why the tax multiplier is weaker is because not all of the income required to pay the tax

(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

(64)

Making Fiscal Policy

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

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

(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.

(66)

Making Fiscal Policy

Balanced budget multiplier

•_{The effects on the equilibrium level of}

(67)

Making Fiscal Policy

Budget deficit

•_{Government spending exceeds tax}

(68)

(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}

(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}

(71)

Making Fiscal Policy

Budget surplus

(72)

(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}

(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}