Chapter 23

Fiscal Policy: Coping with

Inflation and Unemployment
Fred Gottheil

08/29/22
©1999 South-Western College Publishing
1
What is a Fiscal Policy?
Government spending
and taxation to achieve
full employment
without inflation

©1999 South-Western College Publishing

2
What is the difference between
discretionary and
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.
3
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
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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5
 What is the
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
unemployment?
The number of unemployed
divided by the labor force,
U rate = U/ U + E

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 Breakdown of the US Population
and the Labor Force

Persons under 16
Persons in the armed forces
Persons institutionalized

Total Population
Not in Labor Force
Civilian
Noninstitutional
Employed
Population

Civilian Labor Force

Unemployed
 Who measures
unemployment?
The Bureau of Labor Statistics
surveys about 60,000
households each month

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 For current data on
unemployment:
http://stats.bls.gov/eag.table.html
http://stats.bls.gov/cpshome.htm

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 What are some of the
problems in measuring
unemployment?
• Discouraged worker
problem
• Part time workers
• Dishonest workers
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 Who is a
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
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-
time workers?
Part time workers are
counted as fully employed

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 What about people
who are over-qualified
for their jobs?
They are still considered
fully employed

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 What’s a dishonest
worker?
Someone who claims to be
looking for work but
really is not

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 Is the unemployment
Yes! rate valid?
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
rate increase without
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
of unemployment?
• Frictional
• Structural
• Cyclical
• Seasonal
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 What is frictional
unemployment?
Unemployment due to
normal turnover of the
labor force, new entrants
to the labor force, re-
entrants, job leavers 20
 What is structural
unemployment?
Unemployment due to
structural changes such
as new technologies
leading to declines in
demand for some jobs 21
 What is cyclical
unemployment?
Unemployment due to a
recession, or downturn in
the economy

22
What is the natural rate
of unemployment?
The sum of frictional and
structural unemployment

23
 What is considered
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
the natural rate of
unemployment?
The natural rate varies, most
estimates are from 4-6%

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 Have more women
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
the work force today
is female?
Almost half

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 What was the
unemployment rate
during the worst of the
Great Depression?
In 1933, 25% of the labor
force was unemployed

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 Why should we care
about unemployment?
Economic costs, lost
output and income
Social costs

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Are there any benefits of
unemployment?
Allocative benefits
Disciplinary benefits

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 What is Inflation?
The general upward
movement in the
average level of prices

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What is Deflation?
The general decrease in
the average level of
prices

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What is the Consumer
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
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
equals 120, what does
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
the CPI change?
As people’s tastes and
preferences change,
what goes into the
basket will change

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Who measures inflation?
The Bureau of
Labor Statistics

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 For current data on
inflation:
http://stats.bls.gov/cpshome.htm

©1999 South-Western College Publishing

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Problems with the CPI
• Substitution bias
• Changes in quality of
goods
• Use of retail prices
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What are the effects of
unexpected inflation?
Inflation redistributes
income, some people
win, some lose

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Who wins and who loses
from inflation?
Debtors win, creditors lose
Real interest rate =
Nominal rate -expected
inflation
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More winners and losers
of inflation
• Those on fixed incomes lose
• Savers often lose
• Government sometimes wins
• Menu costs of inflation
• Inflation psychology develops
• Inflation and uncertainty 42
 What is a
Recessionary Gap?
The amount by which aggregate
expenditure falls short of a full
employment equilibrium, thus
giving high unemployment-
assume little inflation however

©1999 South-Western College Publishing

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Aggregate Expenditure
The Recessionary Gap

C2+I2+G2+(x-m)2
C1+I1+G1+(x-m)1

less than full employment

full employment
45o

Y1 Yf Real GDP (income)

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 Fiscal policy to help
solve a recessionary gap
• Raise government spending
• Lower taxes
• Attempting to expand or
stimulate the economy
• Remember, multiplier effects
45
Aggregate Expenditure
The Recessionary Gap

C2+I2+G2+(x-m)2
C1+I1+G1+(x-m)1

less than full employment

full employment
45o

Y1 Yf Real GDP (income)

46
46
 What is an
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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Aggregate Expenditure
The Inflationary Gap

C2+I2+G2+(x-m)2
C1+I1+G1+(x-m)1

full employment
New equilibrium
45o

Yf Y1 GDP (income)
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 Fiscal policy to help
solve an inflationary gap
• Lower government spending
• Raise taxes
• Attempting to contract or slow
down the economy

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Aggregate Expenditure
The Inflationary Gap

C2+I2+G2+(x-m)2
C1+I1+G1+(x-m)1

full employment
New equilibrium
45o

Yf Y1 GDP (income)
50
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What is the formula for
the tax multiplier?
-MPC/MPS

51
 Recall the income
(expenditure) multiplier
of the previous chapter,
multiplier = 1/MPS, say
government spending
increases by 100 billion

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$100 billion
$90 MPC = 9/10
$81 MPS = 1/10
$74
...
$1,000
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5
3
Now suppose instead of
raising G by 100, we cut
taxes by 100--will
people spend all of the
100 billion?

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

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 $100 billion
$90 MPC = 9/10
$81 MPS = 1/10
$74
...
1,000 900
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5
6
Thus since -100 = tax cut, and GDP grew by 900,
we have a tax multiplier of -9

Using the tax multiplier, initial change in taxes

times the tax multiplier equals the maximum
change in GDP

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 Practice with the tax
multiplier
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:
1. 15 billion
2. -15 billion
3. 16 billion

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Why are Fiscal Policies
to stem a Recessionary
Gap not problem free?
• Spending becomes permanent
• Ignores the self-correcting
nature of the economy
• It can be very expensive
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60
Why are Fiscal Policies
to stem an Inflationary
Gap not problem free?
To cut government
spending or raise
taxes can be
politically unpopular
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61
Other 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. 62
Time lags could cause 2
problems
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
fiscal 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
out 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
government spending:
http://www.access.gpo.gov/su_docs
/budget/index.html
http://www.cato.org
http://www.publicdebt.treas.gov
http://www.concordcoalition.org
©1999 South-Western College Publishing
66
 What is the Balanced
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?

©1999 South-Western College Publishing

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Say both G and T increase by
20 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 68
What does the Balanced
Budget Multiplier
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?

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