Reduce Government Spending Reduce Unemployment Essay

Policies to reduce Demand Deficient unemployment

Syllabus: Evaluate government policies to deal with the different types of unemployment.

If unemployment is cyclical or demand-deficient, then the best policy to get rid of it will be to boost the level of aggregate demand (Standard Keynesian argument - contested by Neoclassicals).

Sounds easy, but how can the government achieve this? They use expansionary monetary policy and/or fiscal policy the aim is to shift AD to the right remember.

This could mean:

  • Cutting interest rates - this should encourage consumption (Credit) and investment (Borrowing) and, therefore, boost aggregate demand (Monetary Policy)
  • Increasing the Money Supply - More money implies more expanditure (Monetary Policy)
  • Increasing government expenditure - government spending is a crucial component of aggregate demand and so increasing spending, perhaps on education, health or roads, will help boost aggregate demand and reduce unemployment. (Fiscal Policy)
  • Cutting taxes - government could cut direct and/or indirect taxes; both of these actions should encourage consumption . Higher consumption should mean more employees are required to make the additional goods and services demanded. A reduction intaxes on profits might also encourage investment. (Fiscal Policy)

These expansionary fiscal or monetary policies should increase aggregate demand and shift the aggregate demand curve to the right as in figure 1 below.

Put in Keynesian LRAS instead/as well

Figure 1 Expansionary fiscal/monetary policy

This solution appears to be quite simple, but in macroeconomics things are rarely as simple as they first appear! As we already know, policy conflicts can arise, especially the possible effects on inflation of higher aggregate demand.

So, a mixture of monetary policy, fiscal policy and supply-side policies (see later but basically shifting Aggregate Supply to the right)  would normally be used. Governments hope that supply-side policies will boost the capacity of the economy and enable higher aggregate demand, but without the associated inflationary pressures.

In the long run, if there is no shortage of aggregate demand, the cause of the unemployment is likely to lie with supply-side problems, such as geographic and occupational immobility of labour, lack of appropriate skills and training or a lack of information (Structural Unemployment).

This type of unemployment can be tackled by application of appropriate supply-side policies, as previously identified in Section 2.6.

Past paper Essay

May 2010 TZ2

2. (a) Explain why a country may wish to reduce its unemployment rate. [10 marks]

    (b) Evaluate the likely effects on the economy of relying on demand-side policies to reduce the unemployment rate.     [15 marks]

Fiscal Policy

In order to learn and understand fiscal policy or monetary policy it is important to whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust. This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in the form of fiscal policy.

Fiscal policy can be defined as government�s actions to influence an economy through the use of taxation and spending. This type of policy is used when policy-makers believe the economy needs outside help in order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order.

Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports.

Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports

Fiscal policy has an effect on each of these categories. There are two types of fiscal policy: Expansionary and Contractionary.

Expansionary Fiscal Policy

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap � meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.

Contractionary Fiscal Policy

Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.

Fiscal Policy Summary

To summarize, fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economy�s growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.

One thing to remember concerning fiscal policy is that a recession is generally defined as a time period of at least two quarters of consecutive reduction in growth. It may take time to even recognize whether or not there is a recession. With fiscal policy, there will be certain levels of lag time in which conditions will deteriorate before being recognized. At the same time, fiscal policy takes time to implement due to legislative and administrative processes, and those same policies will take time to show results after implementation.

Consumers can also react to these policies positively or negatively. Most consumers would have a positive reaction per say to a policy that lowers taxes, while some will have an issue with a government spending more which will increase the burden of debt on nations citizens.

Nevertheless, fiscal policy is a type of intervention that can help to control the direction of an economy. Deciding if and when it should be used will certainly continue to be debated.


by Aaron Forsythe, 2012




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