© 2005 Thomson C hapter 23 Fiscal Policy: Coping with Inflation and Unemployment

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Frictional, structural, and cyclical unemployment Discouraged and underemployed workers The natural rate of unemployment

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles Winners and losers from inflation Recessionary and inflationary gaps The tax multiplier The balanced budget multiplier Fiscal policy options

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Fiscal Policy Recall that the national economy, if not already in equilibrium, is always moving toward it. But is equilibrium particularly attractive?

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Fiscal Policy Equilibrium tells us nothing about satisfaction or the general state of the economy.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment In order to define full employment, we need to look at the reasons why people may not have jobs.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Cyclical unemployment Unemployment associated with the downturn and recession phases of the business cycle.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Discouraged workers Unemployed people who give up looking for work after experiencing persistent rejection in their attempts to find work.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Many discouraged workers end up in a nonwork culture and remain permanently separated from the productive society.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Underemployed workers Workers employed in jobs that do not utilize their productive talents or experience.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment The unemployment rate for an economy depends on decisions about who belongs in the unemployment pool.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e EXHIBIT 1NUMBER OF WORKERS AND TYPES OF UNEMPLOYMENT

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e 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 = [( ) /10,250] × 100 = 8.3 percent.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e 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 = [( )/10,250] × 100 = 13.7 percent.

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment The critical questions asked is: Are you presently gainfully employed or actively seeking employment?

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Labor force People who are gainfully employed or actively seeking employment.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment Natural rate of unemployment The rate of unemployment caused by frictional plus structural unemployment in the economy.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Equilibrium and Full Employment The economy is considered to be at full employment when the rate of cyclical unemployment is zero.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 33 EXHIBIT 2THE FULL-EMPLOYMENT LEVEL OF THE AGGREGATE SUPPLY CURVE AND THE EFFECTS OF AN INCREASE IN AGGREGATE DEMAND

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e 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 AD 1 to AD 2 in panel b? The price level increases from P = 110 to P = 120.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Understanding Inflation Inflation redistributes income. Some people win and some people lose from the redistribution.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 46 EXHIBIT 3ARECESSIONARY AND INFLATIONARY GAPS

© 2005 Thomson 47 EXHIBIT 3BRECESSIONARY AND INFLATIONARY GAPS

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Closing Recessionary and Inflationary Gaps Government, however, can design public investment projects to close the recessionary gap. Super- highways, public housing, space programs and defense are all projects that could be initiated to absorb the investment funds.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Closing Recessionary and Inflationary Gaps Third, the funds must come from somewhere. Debt financing places burdens on the future economy.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Making Fiscal Policy Fiscal policy Government spending and taxation policy to achieve macroeconomic goals of full employment without inflation.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Making Fiscal Policy Balanced budget Government spending equals tax revenue. The equation is written: G = T, Where G = government spending and T = tax revenue.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Making Fiscal Policy Tax multiplier The equation for the tax multiplier is: -MPC/(1 - MPC).

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Making Fiscal Policy The tax multiplying factor, when MPC = 0.80, is: -0.80/( ) = -4. The $10,000 tax generates a $40,000 decline in national income.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e 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/( ) = 5. The increase in national income generated by the $10,000 tax is $50,000.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e Making Fiscal Policy Budget deficit Government spending exceeds tax revenues.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e EXHIBIT 4SAMPLE BUDGET OPTIONS TO CLOSE A RECESSIONARY GAP ($ BILLIONS)

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e 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?

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Making Fiscal Policy Budget surplus Tax revenues exceed government spending.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e EXHIBIT 5SAMPLE BUDGET OPTIONS TO CLOSE AN INFLATIONARY GAP ($ BILLIONS)

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e 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.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e 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.