The economist John Maynard Keynes was a proponent of expansionary fiscal policy during recessionary periods. According to Keynes, there are idle resources—capital and labor—during a recession. Therefore, it is the job of the government to create additional demand and intervene in order to reduce unemployment. The goal of expansionary monetary policy is to increase aggregate demand and economic growth through cutting interest rates.
Lower interest rates mean that the cost of borrowing is lower. This increases aggregate demand and GDP and decreases cyclical unemployment. Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.
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Negotiate Severance—If You Can. How to File for Unemployment Insurance. Managing Finances During Unemployment. Understanding the Unemployment Rate. Unemployment and the Economy. These resources can be unemployed or underemployed workers, as well as offices, shops, or factories functioning with spare capacity. When an economy functions at full capacity with no idle resources , extra government spending will crowd out private spending. Robert Barro and Paul Krugman, the economists, disagreed about the size of the multiplier in the weeks that followed the enactment of the American Recovery and Reinvestment Act in early Using data on government defence spending during the Second World War, Barro concluded that the multiplier was not larger than 0.
However, Krugman responded that in wartime there are no idle productive resources to take advantage of. People of working age were in work supporting the war effort in factories, and the government used rationing to depress private consumption. In the recessions that followed the Eurozone crisis in , just as new economic research was finding evidence that multipliers in recessions were well above one, many European governments implemented fiscal austerity to balance their budgets.
These countries had poor growth outcomes—another sign that, in deep recessions, the multiplier is greater than one. But some Eurozone countries had no choice but to adopt austerity policies. As we will see in the next section, they had lost the ability to borrow. Consider the three methods discussed in this unit that have been used to estimate the size of the multiplier: the Mafia-related dismissals in Italy, the stimulus highway spending in the US, and wartime defence spending in the US.
Why do you think estimates of the size of the multiplier vary? Use the material in this unit to support your explanation. In the table in Figure We can use FRED to see whether these contributions changed during the recovery phase of the recession. Go to the FRED website. You can watch this short tutorial to understand how FRED works. Make sure the frequency is quarterly. This button also allows you to add other series to your graph. Make sure you select quarterly frequency for all series on your graph.
Now use the data you have downloaded to carry out the following tasks for the period from to Note: To make sure you understand how these FRED graphs are created, you may want to extract the data into your spreadsheet and reproduce the series. Assume the economy is in a recession. How can the government achieve a fiscal stimulus effect on GDP whilst keeping the budget balanced?
From the paradox of thrift, we learned that in a recession, it is counterproductive for the government to offset the automatic stabilization of the economy. We have also learned that using a fiscal stimulus to boost aggregate demand in a deep recession can be justified, under conditions in which the multiplier is greater than one. So why are stimulus policies often followed by policies of austerity? Governments raise revenue in the form of income taxes and taxes on spending, often called Value Added Tax VAT or sales tax.
They also raise money from a variety of other sources including taxes on products like alcohol, tobacco, and petrol—and on wealth, including through inheritance taxes. Government expenditure includes health, education, and defence, as well as public investment such as roads and schools. Government revenue is also used to fund social security transfers, which include unemployment benefits, pensions, and disability benefits. The government also has to pay interest on its debt. Transfers and interest payments are paid out of government revenues, but they do not count in G because the government is not spending money on goods or services.
If the initial situation is one of a zero primary deficit, then it automatically worsens in a business cycle downturn. When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure.
The government borrows by selling bonds. Firms and households buy the bonds. Households usually buy them indirectly, because they are bought by pension funds, from which households buy pensions. Because of the existence of global financial markets, foreigners can also buy home country bonds.
Government bonds are attractive to investors because they pay a fixed interest rate and because they are generally considered a safe investment: the default risk on government bonds is usually low. Investors are likely to want to hold a mixture of safe and risky assets, and government bonds are normally at the safe end of the spectrum. A sovereign debt crisis is a situation in which government bonds come to be considered risky. Such crises are not uncommon in developing and emerging economies, but they are rare in advanced economies.
However, in , there was an increase in interest rates on bonds issued by the Irish, Greek, Spanish, and Portuguese governments, which was a signal of a sharp increase in default risk—the likelihood that the government would be unable to make the required payments on its debt.
It marked the start of the Eurozone crisis. Governments of countries experiencing a sovereign debt crisis may have no alternative to austerity policies if they can no longer borrow, because in this case they cannot spend more than the tax revenue they receive.
A large stock of debt relative to GDP can be a problem because, like a household, the government has to pay interest on its debt and it has to raise revenue to pay the interest, which may require raising tax rates.
However, governments are not like households in that there is no point at which they need to have paid off all their stock of debt—as one set of bonds matures, governments will typically issue more bonds, maintaining a stock of debt this is called rolling over debt, which firms also typically do to finance their operations. Indeed, because government bonds are generally seen as a safe asset outside periods of crisis, there is usually demand for government debt from private investors.
As the long-run data for the UK in Figure Ryland Thomas and Nicholas Dimsdale. The level of indebtedness of a government is measured in relation to the size of the economy, that is, as a percentage of GDP. The two big upward spikes in the British debt to GDP ratio in the twentieth century were caused by the need for the government to borrow to finance the war effort.
Financial crises also raise government debt. Governments borrow both to bail out failing banks and to support the economy in the lengthy recessions that follow financial crises. The British government ran a primary budget surplus in every year except one from until , which helped to reduce the debt-to-GDP ratio.
But the ratio may also fall even when there is a primary budget deficit, as long as the growth rate of the economy is higher than the interest rate.
During the period of rapid reduction of the British debt ratio, in addition to the primary surpluses, there was moderate growth, low nominal interest rates set by the government, and moderate inflation. Why does inflation help a country reduce its debt ratio? Because the face value of government bonds the level of debt is denominated in nominal terms.
As we discuss further in Unit 15, inflation reduces the real value of debt. For many advanced economies, there have been extended periods in which the growth rate has been higher than the interest rate. Brad DeLong, an economist, has pointed out that this has been true for the US for almost all of the last years.
How would you use the criteria of Pareto improvement and fairness to evaluate the use of stimulus policies and bank bailouts following the global financial crisis of —? Hint: you might want to look back at Sections 5.
Countries with aging populations have demographic trends that imply upward pressure on the debt-to-GDP ratio, because the proportion of government revenue spent on state pensions, healthcare, and social care for the elderly will increase. Many governments and voters are facing a difficult choice: do they limit benefits, or put up taxes? To get a feel for the effects of policy interventions, The Economist provides a modelling tool to experiment as a hypothetical policymaker.
Try different combinations of primary budget balance, growth rate, nominal interest rate, and inflation rate as methods of preventing the debt ratio from continuously rising in a country of your choice.
In Unit 13 we saw that agrarian economies suffered shocks from wars, disease, and the weather. In modern economies, what happens in the rest of the world is a source of shocks, and also affects how domestic economic policy works. To avoid making mistakes, policymakers need to know about these interactions. When the Chinese economy slowed down from a growth rate of This is because a high proportion of UK exports go to the EU. As we have seen, the size of the multiplier is reduced by the marginal propensity to import.
When autonomous demand goes up, it stimulates spending, and some of the products bought are produced abroad. This dampens the domestic upswing. Trade with other countries constrains the ability of domestic fiscal policymakers to use stimulus policies in a recession.
A striking example comes from France in the s. At the start of the s, the French economy remained weak following the oil shocks of the s, which disrupted the world economy.
His appointed prime minister, Pierre Mauroy, implemented a program to stimulate aggregate demand through increased government spending and tax cuts in the multiplier model, this is a rise in G and a fall in t , the tax rate.
The purple bars show the outcomes for France and the orange bars show the outcomes for Germany. The figure presents the outcomes for three years. In the first year, there was no stimulus, in the second, there was a fiscal stimulus in France, and the third year was the year following the stimulus. OECD Statistics. If you look at Figure Meanwhile, in Germany, the budget remained close to balance through the three years. The expansionary demand policy in France was an exception in Europe.
There was an initial boost to French growth in from 1. The upturn in the French economy led French households to increase their spending, but much of this was on foreign goods.
The French stimulus spilled over to countries that produced more competitive products, like Japan electronic goods and Germany cars. There was a surge of imports into France: measured relative to the level in , imports were higher by The French stimulus policy mostly benefitted its trading partners who had more competitive goods. Between and , the French government had to devalue the franc three times in an effort to make French goods more competitive with those produced abroad.
Mauroy stepped down in and the new prime minister introduced an austerity policy. The Mitterrand experiment highlights the limits of using a fiscal stimulus to successfully stabilize a deep recession.
In the case of France, the policy was badly designed and it delayed the adjustment of the French economy to the shocks that had affected it in the s. Note that the problem in France was not only high unemployment.
Injecting more aggregate demand stimulated spending, but not spending on French output. A fiscal stimulus may not be the only or best policy option in a recession: Olivier Blanchard, the former chief economist of the IMF, explains how fiscal consolidation worked in the case of Latvia in , even though he had initially advised against it.
The multiplier was very low and the spillover effects to other economies meant that most of the stimulus leaked out of France. It would fit in the final row of the third column in Figure Assume the world is made up of just two countries, or blocs, called North and South.
The world is in a deep recession. The situation can be described using the coordination game used for investment in Unit Here the two strategies are Stimulus and No stimulus. Explain in words how the coordination game reflects the problems faced by policymakers in the two countries that arise because of their interdependence. We now have two models for thinking about total output, employment, and the unemployment rate in the economy:.
When we put the models together, we will be able to explain how the economy fluctuates around the long-run labour market equilibrium over the business cycle. The labour market model from Unit 9 is shown in Figure We will see that the economy tends to fluctuate over the business cycle around the unemployment rate shown at point A. In the example in Figure Note that in the labour market diagram, the horizontal axis measures the number of workers, so we can measure employment and unemployment along it.
In the multiplier diagram, output is on the horizontal axis. The production function connects employment and output, and in this model, the production function is very simple.
Short-term fluctuations in employment are caused by changes in aggregate demand. As we saw in Unit 9, when employment is below the labour market equilibrium because of deficient aggregate demand, the additional unemployment is called cyclical unemployment. If there is excess demand, above labour market equilibrium, then unemployment is below its equilibrium level. The level of output here is called the normal level of output. Any other level of aggregate demand would produce a different level of employment.
Consider a rise in investment that shifts the aggregate demand curve up to AD high , so that output and employment rise. The additional employment is called cyclical employment. If the aggregate demand curve shifts down, then through the multiplier process, output and employment fall to C.
The additional unemployment is called cyclical unemployment. In our study of business cycle fluctuations using the multiplier model, we have made a number of ceteris paribus assumptions.
We have assumed that prices, wages, the capital stock, technology, and institutions are constant. We use the term short run to refer to these assumptions. The purpose of the model is to predict what happens to output, aggregate demand, and employment when there is a demand shock a shock to investment, consumption or exports , or when policymakers use fiscal policy or monetary policy to shift the aggregate demand curve.
Notice that in Figure The labour market model is a medium-run model where wages and prices can change, unlike in the multiplier model, which is a short-run model. So a short-run equilibrium in the multiplier model may not be a medium-run equilibrium in the labour market model.
The following are the labour market and the multiplier diagrams, representing the medium-run supply side and the short-run demand side of the aggregate economy, respectively:.
Economies often experience shocks to aggregate demand, such as a decline in business investment or an increase in desired savings by households. These shocks tend to be amplified by the process described by the multiplier. In addition to their first-round effects, there are second-round or other indirect effects due to further declines in spending. In the second half of the twentieth century, the advanced economies enjoyed a great decline in economic instability, which was due in part to larger governments and the existence of automatic stabilizers that moderated swings in aggregate demand.
While active fiscal policy played its part, it had a mixed record. France discovered in the early s that a poorly planned fiscal expansion can lead to a fiscal deficit with little benefit to the domestic economy.
In , the world was reminded that even the rich countries can suffer from economic crises, and the importance of fiscal policy in deep recessions was reaffirmed. Unfortunately for the Eurozone, the hardest-hit countries were unable to implement the necessary fiscal stimulus because of fears of sovereign debt crises.
Christina D. Journal of Economic Perspectives 7 2 May : pp. John Maynard Keynes. The Economic Consequences of the Peace. London: Palgrave Macmillan. The End of Laissez-Faire. Amherst, NY: Prometheus Books. This is a summary of the paper published in Alan Auerbach and Yuriy Gorodnichenko. American Economic Review 7 July : pp. Sylvain Leduc and Daniel Wilson. Tim Harford. Financial Times. Paul Krugman.
Updated 9 October Jonathan Portes. Noah Smith. Updated 7 January Simon Wren-Lewis. Mainly Macro. Updated 24 August International Monetary Fund. Bradford DeLong.
Washington Center for Equitable Growth. Updated 5 April The Economist. Updated 26 November Olivier Blanchard. Updated 11 June This ebook is developed by the CORE project. More information and additional resources for learning and teaching can be found at www. The Economy. Unit 14 Unemployment and fiscal policy Themes and capstone units History, instability, and growth Global economy Innovation Politics and policy. History, instability, and growth Politics and policy.
View the latest data at OWiD. Question The MPC is normally less than 1 as some households are able to smooth their consumption. The MPC is the proportion of the additional income received that is spent on consumption. Here it is given by c 1. The slope of the line gives the MPC. Households that smooth consumption will increase spending by less than the amount their income increases.
The total broad wealth equals material wealth plus expected future earnings. A household adjusts its precautionary saving in response to changes in its target wealth. The material wealth is the net worth, that is, financial wealth plus value of house minus its debt. This is the definition of broad wealth. A household adjusts its precautionary saving in response to the gap positive or negative between its actual and target wealth. If the target wealth is above its expected wealth, then the household will increase its savings to fill the gap, reducing its consumption as a result.
Innovation Politics and policy. The central bank can ensure that all projects will be undertaken by cutting the interest rate to 1. When the demand is expected to permanently increase beyond the capacity of existing plants and equipment, the level of investment increases due to an upward shift in the expected profit rate. An expected rise in energy prices leads to a fall in the expected profit rates, resulting in fewer projects being profitable at a given interest rate.
This results in reduced investment. Therefore only Firm A undertakes its project 1. At an interest rate of 1. With a permanent positive demand shock, the heights of the columns remain unchanged but the amount of investment that is profitable increases.
This increases the widths of the columns, leading to higher investment for any given interest rate. The rise in energy prices increases costs for firms so expected profits decrease, implying that fewer projects have an expected profit rate greater than the interest rate.
Ceteris paribus , an increase in the interest rate would lead to a fall in investment due to an inward shift of the investment line. A rise in corporate tax would shift the investment line outwards. A forecast of a permanent demand increase shifts the investment line outwards. A steeper line indicates the higher sensitivity of the level of aggregate investment to changes in interest rate.
The investment line represents the relationship between investment and interest rate, ceteris paribus. Therefore the fall in investment would be shown by a movement up the original line from E to C for example , not a shift of the line.
A rise in corporate tax would decrease the expected profit rate, shifting the investment line inwards. This results in a fall in investment. Higher demand makes it profitable to invest in larger projects, increasing investment at a given interest rate. A steeper line means smaller changes in investment when the interest rate moves, that is, lower sensitivity of investment to the interest rate. Politics and policy. So that the additional spending is less than their increase in income.
And when this additional spending becomes income to someone else, they sill save some and spend even a smaller amount. This will continue until the total change in savings is equal to the initial increase in spending. When this occurs there is nothing left to spend and the process stops. To understand the multiplier process we must gain a better understanding of how consumption and saving respond to changes in income. It is consumption that is not related to income.
If an economy does not produce a thing, would there still be some consumption? Yes, but how? Given these assumptions we can calculate savings S. With these assumptions there are only two things that consumers can do with their income, spend it C or save it S. APC is the fraction of the economy's total income that is spent consumed and APS is the fraction of total income that is saved.
Given our assumptions there are only two things that consumers can do with their income spend it or save it. If you add the fraction of the total income that is spent APC and the fraction of the total income that is saved APS we get all of our income, or 1. Can you think of anything else that we can do with our income besides spend it or save it? Many students will answer "invest it". But what does investment mean in economics?
Investment is the accumulation of capital. Therefore, "investment" occurs when a carpenter buys a hammer or if McDonald's builds a new restaurant. Putting money into the stock market is NOT investment, it is savings. Earlier we explained that the multiplier works " because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else.
MPC is the fraction of the economy's additional income that is spent consumed and APS is the fraction of additional income that is saved.
MPC is then equal to 0. If you remember your 8th grade math you would recognize that our formula for MPC is actually the slope of the consumption graph. Note that in our table MPS equals 0. But is the fraction of additional income that is spent and saved really constant for all levels of income? Would they both spend and save the same fraction of this additional income? This means the slope of the consumption graph should get smaller flattens out as GDP increases.
We will assume that the MPC is constant in this course. Given our simplifying assumptions we have an economy with only consumers and businesses. What is the total impact of this investment on the economy? What do these people do with this additional income? Well, they spend a part and save a part.
How much do they spend and save? What concept tells us the change in consumption that results from additional income? What will they do with this income? This process will go on and on.
When will it stop? If you do this you will get the following total changes:. To see the multiplier in reverse read: : artbuchwaldmultiplier. We know that a small initial change in spending will result in a multiplied effect on total spending in the economy, or:.
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