1 Chapter 23 Fiscal Policy: Coping with Inflation and Unemployment Fred Gottheil 10/4/2015 © ©1999...

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Chapter 23Chapter 23Chapter 23Chapter 23Fiscal Policy: Coping with Fiscal Policy: Coping with Inflation and UnemploymentInflation and Unemployment

Fred GottheilFred Gottheil

04/19/23

©©1999 South-Western College Publishing

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What is a Fiscal Policy?What is a Fiscal Policy?What is a Fiscal Policy?What is a Fiscal Policy?Government spending

and taxation to achieve full employment without inflation

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What is the difference between What is the difference between discretionary and discretionary and

nondiscretionary fiscal policy?nondiscretionary fiscal policy?

What is the difference between What is the difference between discretionary and discretionary and

nondiscretionary fiscal policy?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.

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Who is unemployed?Who is unemployed?Anyone who is at least 16 years of age and is actively seeking employment

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Who makes up the Who makes up the Labor Force?Labor Force?

All non-institutionalized people 16 years of age and older who are either working or actively looking for work

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What is the What is the Unemployment rate?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

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How do we measure How do we measure unemployment?unemployment?

The number of unemployed divided by the labor force,

U rate = U/ U + E

Breakdown of the US Population Breakdown of the US Population and the Labor Force and the Labor Force

Breakdown of the US Population Breakdown of the US Population and the Labor Force and the Labor Force

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Persons under 16Persons in the armed forcesPersons institutionalized

CivilianNoninstitutionalPopulation

Total PopulationNot in Labor Force

Civilian Labor Force

Employed

Unemployed

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Who measures Who measures unemployment?unemployment?

The Bureau of Labor Statistics surveys about 60,000 households each month

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For current data on For current data on unemployment:unemployment:

For current data on For current data on unemployment:unemployment:

http://stats.bls.gov/eag.table.htmlhttp://stats.bls.gov/cpshome.htm

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What are some of the What are some of the problems in measuring problems in measuring

unemployment?unemployment?

What are some of the What are some of the problems in measuring problems in measuring

unemployment?unemployment?• Discouraged worker

problem• Part time workers• Dishonest workers

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Who is aWho is aDiscouraged Worker?Discouraged Worker?

A person who drops out of the work force because he or she cannot find a job

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Are Discouraged Workers Are Discouraged Workers counted in the labor force?counted in the labor force?

No! People who have quit looking for work are not counted as part of the labor force

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What about part-What about part-time workers?time workers?

Part time workers are counted as fully employed

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What about people What about people who are over-qualified who are over-qualified

for their jobs?for their jobs?They are still considered

fully employed

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What’s a dishonest What’s a dishonest worker?worker?

What’s a dishonest What’s a dishonest worker?worker?

Someone who claims to be looking for work but really is not

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Is the unemployment Is the unemployment rate valid?rate valid?Yes!

As long as we are consistent, we can get an accurate comparison from one time period to the next

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Can the unemployment Can the unemployment rate increase without rate increase without anyone losing a job?anyone losing a job?

If more people enter the work force than the number of new jobs generated, the unemployment rate increases

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What are different types What are different types of unemployment?of unemployment?

• Frictional• Structural• Cyclical• Seasonal

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What is frictional What is frictional unemployment?unemployment?

What is frictional What is frictional unemployment?unemployment?

Unemployment due to normal turnover of the labor force, new entrants to the labor force, re-entrants, job leavers

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What is structural What is structural unemployment?unemployment?

What is structural What is structural unemployment?unemployment?

Unemployment due to structural changes such as new technologies leading to declines in demand for some jobs

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What is cyclical What is cyclical unemployment?unemployment?What is cyclical What is cyclical unemployment?unemployment?

Unemployment due to a recession, or downturn in the economy

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What is the natural rate What is the natural rate of unemployment?of unemployment?

What is the natural rate What is the natural rate of unemployment?of unemployment?

The sum of frictional and structural unemployment

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What is consideredWhat is consideredFull Employment?Full Employment?

An employment level at which the actual rate of unemployment is equal to the natural rate of unemployment

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What is considered to be What is considered to be the natural rate of the natural rate of unemployment?unemployment?

The natural rate varies, most estimates are from 4-6%

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Have more women Have more women entered the work force?entered the work force?

Since the 1950’s there has been a large increase in the number of women in the work force

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What percentage of What percentage of the work force today the work force today

is female?is female?Almost half

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What was the What was the unemployment rate unemployment rate

during the worst of the during the worst of the Great Depression?Great Depression?

In 1933, 25% of the labor force was unemployed

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Why should we care Why should we care about unemployment?about unemployment?Why should we care Why should we care

about unemployment?about unemployment?

Economic costs, lost output and income

Social costs

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Are there any benefits of Are there any benefits of unemployment?unemployment?

Are there any benefits of Are there any benefits of unemployment?unemployment?

Allocative benefitsDisciplinary benefits

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What is Inflation?What is Inflation?The general upward

movement in the average level of prices

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What is Deflation?What is Deflation?The general decrease in

the average level of prices

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What is the Consumer What is the Consumer Price Index (CPI)?Price Index (CPI)?

A measure of the cost of a fixed “market basket” of consumer goods and services

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How is the CPI How is the CPI calculated?calculated?

How is the CPI How is the CPI calculated?calculated?

CPI = Value of the market basket in the current period

Value of the market basket in

the base period

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If the value of the CPI If the value of the CPI equals 120, what does equals 120, what does

this mean?this mean?

If the value of the CPI If the value of the CPI equals 120, what does equals 120, what does

this mean?this mean?The fixed market basket of

goods costs 20% more than in the base period of time

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Does the makeup of Does the makeup of the CPI change?the CPI change?

As people’s tastes and preferences change, what goes into the basket will change

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Who measures inflation?Who measures inflation?The Bureau ofLabor Statistics

©©1999 South-Western College Publishing

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For current data on For current data on inflation:inflation:

For current data on For current data on inflation:inflation:

http://stats.bls.gov/cpshome.htm

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Problems with the CPIProblems with the CPIProblems with the CPIProblems with the CPI

• Substitution bias• Changes in quality of

goods• Use of retail prices

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What are the effects of What are the effects of unexpected inflation?unexpected inflation?

What are the effects of What are the effects of unexpected inflation?unexpected inflation?

Inflation redistributes income, some people win, some lose

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Who wins and who loses Who wins and who loses from inflation?from inflation?

Who wins and who loses Who wins and who loses from inflation?from inflation?

Debtors win, creditors loseReal interest rate =

Nominal rate -expected inflation

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More winners and losers More winners and losers of inflationof inflation

More winners and losers More winners and losers of inflationof inflation

• Those on fixed incomes lose• Savers often lose• Government sometimes wins• Menu costs of inflation• Inflation psychology develops• Inflation and uncertainty

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What is aWhat is aRecessionary Gap?Recessionary Gap?

What is aWhat is aRecessionary Gap?Recessionary Gap?

The amount by which aggregate expenditure falls short of a full employment equilibrium, thus giving high unemployment-assume little inflation however

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The Recessionary GapThe Recessionary Gap

C1+I1+G1+(x-m)1

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less than full employment

C2+I2+G2+(x-m)2

full employment

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Agg

rega

te E

xpen

ditu

re

Real GDP (income)YfY1

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Fiscal policy to help Fiscal policy to help solve a recessionary gapsolve a recessionary gap

Fiscal policy to help Fiscal policy to help solve a recessionary gapsolve a recessionary gap• Raise government spending• Lower taxes• Attempting to expand or

stimulate the economy• Remember, multiplier effects

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The Recessionary GapThe Recessionary Gap

C1+I1+G1+(x-m)1

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less than full employment

C2+I2+G2+(x-m)2

full employment

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Agg

rega

te E

xpen

ditu

re

Real GDP (income)YfY1

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What is anWhat is anInflationary Gap?Inflationary Gap?

What is anWhat is anInflationary Gap?Inflationary Gap?

The amount by which aggregate expenditure exceeds the full employment equilibrium, thus a booming economy, leading to demand pull inflation.

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The Inflationary GapThe Inflationary Gap

C1+I1+G1+(x-m)1

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full employment

C2+I2+G2+(x-m)2

New equilibrium

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Agg

rega

te E

xpen

ditu

re

GDP (income)Y1Yf

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Fiscal policy to help Fiscal policy to help solve an inflationary gapsolve an inflationary gap

Fiscal policy to help Fiscal policy to help solve an inflationary gapsolve an inflationary gap• Lower government spending• Raise taxes• Attempting to contract or slow

down the economy

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The Inflationary GapThe Inflationary Gap

C1+I1+G1+(x-m)1

45o

full employment

C2+I2+G2+(x-m)2

New equilibrium

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Agg

rega

te E

xpen

ditu

re

GDP (income)Y1Yf

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What is the formula for What is the formula for the tax multiplier?the tax multiplier?

What is the formula for What is the formula for the tax multiplier?the tax multiplier?

-MPC/MPS

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Recall the income Recall the income (expenditure) multiplier (expenditure) multiplier of the previous chapter, of the previous chapter, multiplier = 1/MPS, say multiplier = 1/MPS, say government spending government spending

increases by 100 billionincreases by 100 billion

Recall the income Recall the income (expenditure) multiplier (expenditure) multiplier of the previous chapter, of the previous chapter, multiplier = 1/MPS, say multiplier = 1/MPS, say government spending government spending

increases by 100 billionincreases by 100 billion

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$100 billion$90$81$74

$1,000

...

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MPC = 9/10MPS = 1/10

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Now suppose instead of Now suppose instead of raising G by 100, we cut raising G by 100, we cut

taxes by 100--will taxes by 100--will people spend all of the people spend all of the

100 billion?100 billion?

Now suppose instead of Now suppose instead of raising G by 100, we cut raising G by 100, we cut

taxes by 100--will taxes by 100--will people spend all of the people spend all of the

100 billion?100 billion?

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Answer is No, some will Answer is No, some will be saved--assume again be saved--assume again MPC=.9, MPS=.1, thus MPC=.9, MPS=.1, thus 90% of tax cut is spent 90% of tax cut is spent

or 90 billion initial or 90 billion initial change in spendingchange in spending

Answer is No, some will Answer is No, some will be saved--assume again be saved--assume again MPC=.9, MPS=.1, thus MPC=.9, MPS=.1, thus 90% of tax cut is spent 90% of tax cut is spent

or 90 billion initial or 90 billion initial change in spendingchange in spending

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$100 billion$90$81$74

1,000

...

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MPC = 9/10MPS = 1/10

900

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Thus since -100 = tax cut, and GDP grew by 900, we have a tax multiplier of -9

Using the tax multiplier, initial change in taxestimes the tax multiplier equals the maximum

change in GDP

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Practice with the tax Practice with the tax multipliermultiplier

Practice with the tax Practice with the tax multipliermultiplier

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?

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Answers:Answers:Answers:Answers:

1. 15 billion2. -15 billion3. 16 billion

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Why are Fiscal Policies Why are Fiscal Policies to stem a Recessionary to stem a Recessionary Gap not problem free?Gap not problem free?

Why are Fiscal Policies Why are Fiscal Policies to stem a Recessionary to stem a Recessionary Gap not problem free?Gap not problem free?

• Spending becomes permanent• Ignores the self-correcting

nature of the economy• It can be very expensive

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Why are Fiscal Policies Why are Fiscal Policies to stem an Inflationary to stem an Inflationary Gap not problem free?Gap not problem free?

Why are Fiscal Policies Why are Fiscal Policies to stem an Inflationary to stem an Inflationary Gap not problem free?Gap not problem free?

To cut government spending or raise taxes can be politically unpopular

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Other problems with fiscal policyOther problems with fiscal policy Other problems with fiscal policyOther 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.

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Time lags could cause 2 Time lags could cause 2 problemsproblems

Time lags could cause 2 Time lags could cause 2 problemsproblems

1. Miss the boat, problem over before policy gets going

2. Destabilize, rather than stabilize the economy

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Another possible problem with Another possible problem with fiscal policy, crowding outfiscal policy, crowding out

Another possible problem with Another possible problem with fiscal policy, crowding outfiscal 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.

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Keynesians see little crowding Keynesians see little crowding out in recessionary timesout in recessionary times

Keynesians see little crowding Keynesians see little crowding out in recessionary timesout 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.

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For information on For information on government spending:government spending:

For information on For information on government spending:government spending:

http://www.access.gpo.gov/su_docs/budget/index.html

http://www.cato.orghttp://www.publicdebt.treas.govhttp://www.concordcoalition.org

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What is the Balanced What is the Balanced Budget Multiplier?Budget Multiplier?

What is the Balanced What is the Balanced Budget Multiplier?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?

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Say both G and T increase by Say both G and T increase by 20 billion, MPC = .8, MPS=.220 billion, MPC = .8, MPS=.2Say both G and T increase by Say both G and T increase by 20 billion, MPC = .8, MPS=.220 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

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What does the Balanced What does the Balanced Budget Multiplier Budget Multiplier

always equal?always equal?

What does the Balanced What does the Balanced Budget Multiplier Budget Multiplier

always equal?always equal?ONE

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• 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?

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•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?