Coping with Inflation and Unemployment: Fiscal Policy in Action

1. Chapter 23 Fiscal Policy: Coping with Inflation and Unemployment Gottheil — Principles of Economics, 7e

2. Economic Principles • Frictional, structural, and cyclical unemployment • Discouraged and underemployed workers • The natural rate of unemployment • Winners and losers from inflation Gottheil — Principles of Economics, 7e

3. Economic Principles • Recessionary and inflationary gaps • The tax multiplier • The balanced budget multiplier • Fiscal policy options • The business cycle Gottheil — Principles of Economics, 7e

4. Fiscal Policy Recall that the national economy, if not already in equilibrium, is always moving toward it. But is equilibrium particularly attractive? Gottheil — Principles of Economics, 7e

5. Fiscal Policy When the economy is in equilibrium, it can sometimes be distressful. Equilibrium tells us nothing about satisfaction or the general state of the economy. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

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

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. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

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 specific technology. It is difficult for them to start over again. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

13. Equilibrium and Full Employment Cyclical unemployment • Unemployment associated with the downturn and recession phases of the business cycle. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

15. Equilibrium and Full Employment Many discouraged workers end up in a nonwork culture and remain permanently separated from the productive society. Gottheil — Principles of Economics, 7e

16. Equilibrium and Full Employment Underemployed workers • Workers employed in jobs that do not utilize their productive talents or experience. Gottheil — Principles of Economics, 7e

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. Gottheil — Principles of Economics, 7e

18. Equilibrium and Full Employment The unemployment rate for an economy depends on decisions about who belongs in the unemployment pool. Gottheil — Principles of Economics, 7e

19. Counterfeit Unemployment Not everybody who’s unemployed is really unemployed. • There are people who opt out of employment using any number of excuses. • There are those who cannot hold on to a job. Gottheil — Principles of Economics, 7e

20. EXHIBIT 1 NUMBER OF WORKERS AND TYPES OF UNEMPLOYMENT Gottheil — Principles of Economics, 7e

21. 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 Gottheil — Principles of Economics, 7e

22. 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 Gottheil — Principles of Economics, 7e

23. 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. Gottheil — Principles of Economics, 7e

24. Equilibrium and Full Employment The critical questions asked is: Are you presently gainfully employed or actively seeking employment? Gottheil — Principles of Economics, 7e

25. Equilibrium and Full Employment Labor force • People who are gainfully employed or actively seeking employment. Gottheil — Principles of Economics, 7e

26. 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. Gottheil — Principles of Economics, 7e

27. 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. Gottheil — Principles of Economics, 7e

28. Equilibrium and Full Employment Natural rate of unemployment • The rate of unemployment caused by frictional plus structural unemployment in the economy. Gottheil — Principles of Economics, 7e

29. 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. Gottheil — Principles of Economics, 7e

30. Equilibrium and Full Employment The economy is considered to be at full employment when the rate of cyclical unemployment is zero. Gottheil — Principles of Economics, 7e

31. 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. Gottheil — Principles of Economics, 7e

32. 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. Gottheil — Principles of Economics, 7e

33. 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. Gottheil — Principles of Economics, 7e

34. EXHIBIT 2 THE FULL-EMPLOYMENT LEVEL OF THE AGGREGATE SUPPLY CURVE AND THE EFFECTS OF AN INCREASE IN AGGREGATE DEMAND Gottheil — Principles of Economics, 7e

35. 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. Gottheil — Principles of Economics, 7e

36. 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. Gottheil — Principles of Economics, 7e

37. Understanding Inflation Inflation redistributes income. Some people win and some people lose from the redistribution. Gottheil — Principles of Economics, 7e

38. 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. Gottheil — Principles of Economics, 7e

39. 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. Gottheil — Principles of Economics, 7e

40. 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. Gottheil — Principles of Economics, 7e

41. 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. Gottheil — Principles of Economics, 7e

42. 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. Gottheil — Principles of Economics, 7e

43. 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. Gottheil — Principles of Economics, 7e

44. 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. Gottheil — Principles of Economics, 7e

45. 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. Gottheil — Principles of Economics, 7e

46. 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. Gottheil — Principles of Economics, 7e

47. EXHIBIT 3A RECESSIONARY AND INFLATIONARY GAPS Gottheil — Principles of Economics, 7e

48. EXHIBIT 3B RECESSIONARY AND INFLATIONARY GAPS Gottheil — Principles of Economics, 7e

49. 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. Gottheil — Principles of Economics, 7e

50. 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. Gottheil — Principles of Economics, 7e