Evaluate the view that full employment should be the primary macro-economic objective of governments. [25]

The main macro-economic objectives of governments include ensuring stable prices and low inflation; promoting economic growth, both in terms of actual and potential growth; full employment (or conversely low unemployment), and ensuring a healthy balance of payments (BOP). This paper argues that, on the one hand, while governments should aim for full employment, full employment should not just be their primary macro-economic objective.   

Unemployment is defined as the situation where those who are able and willing to work are not able to get jobs, and full employment involves zero or very low unemployment. (In economic theory, there are many types of unemployment, such as frictional unemployment and demand-deficient unemployment, among other examples.) In practice, there will always be some frictional unemployment as people are looking for new jobs or leaving school. It can be argued that an unemployment rate of around three percent is close to full employment. However, it is difficult to determine the full employment level precisely. Full employment implies that the economy is operating at its full capacity and there is no output gap or demand-deficient unemployment.

One of the most important reasons that governments target full employment is that because high unemployment has various social and economic costs. First, unemployed citizens will earn little income, enabling little consumption as they do not have much disposable income. Also, the unemployed may become less motivated and less skilled, losing their human capital, which makes it more difficult to find employment in the future, and with a lack of skills, even with economic opportunities, they cannot get jobs. Also, during periods of high unemployment, the government will have to spend more on unemployment benefits and other transfer payments, which may increase government borrowing. Finally, unemployment may exacerbate social problems such as crime, vandalism and social alienation, especially if unemployment is concentrated among young people, for example in Spain during the financial crisis, when youth unemployment rose massively. Therefore, given the social and economic costs of unemployment, there are many benefits to achieving full employment.

To achieve full employment, Keynesian economists will argue that it is necessary to increase AD when the economy is in a recession. For example, this can be achieved by expansionary fiscal or expansionary monetary policy, which means increasing government spending and reducing direct taxes, and increasing money supply and reducing interest rates respectively. These expansionary policies will cause AD to increase and shift to the right, increasing inflation if the economy is at or near the full employment level, but if there is spare capacity or un-utilised resources there should only be a limited increase in inflation. Therefore, there is a strong economic case for aiming for full employment through demand management policies. And the Phillips curve suggests there is a trade-off between inflation. Therefore, achieving full employment may cause the side effect of demand-pull inflation.

On the other hand, not all economists agree that full employment should be the primary objective of governments. They argue that unemployment cannot be reduced below the natural rate of unemployment (or NAIRU, or Non Accelerating Inflation Rate of Unemployment) without causing inflation. Keeping inflation low is also another objective of governments. Also, any reduction in unemployment below the natural rate, due to demand management policies, will just be temporary. This is because the economy will return to the equilibrium level of national output. Therefore, monetarist economists do not believe there is any point in reducing unemployment below the natural rate because the only effect will be to increase inflation. Therefore, according to monetarist economists, attempts to achieve ‘full employment’ of three percent may conflict with other macro-economic objectives, such as higher inflation. For example, many economies have an inflation target as the primary objective of their Central Bank, such as the Federal Reserve, and the economic argument here is that if low inflation is achieved, it will enable economic stability and encourage investment and sustainable growth in the long term. This is preferable to a government using demand-management policies and causing economic boom and bust cycles.

However, another way of aiming for full employment is to use long run supply side policies to try and reduce the natural rate of unemployment. For example, increased training opportunities and better education can upgrade the skills of workers and reduce structural unemployment, which is what initiatives such as SkillsFuture aim to achieve. However, these economic policies will take time and it may not be possible for the government to reduce all unemployment because of imperfect information and bounded rationality on the part of government agents.

And low unemployment can also be achieved through keeping inflation low and maintaining steady and sustainable growth. For example, in the 1990s, both unemployment and inflation fell due to supply side policies and effective demand management. Therefore, this suggests that a low inflation target can also be effective in meeting other objectives. 

In conclusion, overall, low unemployment is a desirable objective, but the economic policies to achieve this need careful examination because of their limitations and alternative macro-economic objectives. Increasing AD will only be effective if there is a recession and spare capacity in the economy. To reduce the natural rate, long run supply side policies will also be needed. In addition, full employment does not necessarily have to be inflationary too, as economic growth is sustainable, we could get close to full employment without inflationary pressures.

JC Economics Essays – This A level economics essay was based on lecture material from a UK economics tutor. It was in response to an adapted question from the A level Economics syllabus. Also, it was written during examination conditions of time pressure. What did you learn from this response, and what economic theories did it tap on to addressing the economics essay question? However, this economics paper is not very strong in the anti-thesis arguments - what could be done better? How could the other side of the story or narrative be made even better? In addition, there were some economics terms which were mentioned - did the writer define the terms? How could the writer have woven the definition of the terms into the sentences? These critical thinking questions should be asked when you read economics essays. 

At JC Economics Essays, we focus on strong economic writing skills, clear and direct explanations of core economic concepts, and the use of relevant, real-world examples to strengthen arguments. And we also strengthen students’ understanding of economics as a subject. We also focus on critical thinking and evaluating economic arguments. Thank you for supporting us, and cheers! 

A government decides that its economy is currently operating with an unacceptably high level of unemployment. Discuss the view that the government's best option as a method of reducing unemployment is to use discretionary fiscal policy. [15]

Unemployment refers to the situation where people are actively seeking employment but are unable to find work or unwilling to accept the jobs that are currently available. There are many types of unemployment, such as real-wage unemployment, demand-deficient (cyclical) unemployment, structural unemployment, seasonal, and frictional unemployment. In this essay, I will be discussing whether discretionary fiscal policy is the best option to reduce unemployment.

(Insert AD-AS diagram)

In figure 1, the economy was originally below the full employment level at Y1. In order to reduce unemployment, the government can use expansionary fiscal policy to shift AD1 to AD2 so that Y1 will reach Yf which will reach full employment level. Expansionary fiscal policy involves increasing government spending and reducing direct taxes. There are two main types of direct taxes, personal income tax and corporate income tax. When personal income tax is reduced, households will have more disposable income, and thus consumption will increase. Moreover, when corporate income tax is reduced, firms will have more post-tax profits, and thus investments will increase. Since AD = C + I + G + (X-M), AD will increase and shift to the right, hence solving the problem of demand-deficient unemployment.

However, there are limitations to expansionary fiscal policy. Firstly, it can be massively limited by tax insensitivity. Even when corporate taxes are cut, firms may not invest during an economic downturn as they are likely to be pessimistic about the future. Similarly, despite a reduction in personal income taxes, households who are fearful of future pay cuts and retrenchment are more likely to save rather than spend any potential increase in disposable income. Secondly, it may also result in the crowding out effect. Expansionary fiscal policy involves running a higher budget deficit that is probably financed from increased borrowing, especially since increases in government spending are sometimes matched by decreases in the rate of taxes. The demand for loanable funds rises and hence raises interest rates, which in turn deters consumption and investment. Higher interest rates will also cause the currency to appreciate, thereby curbing net exports because exports appear relatively more expensive while imports appear relatively cheaper. The expansionary effects of the budget deficit are therefore negated by a reduction in consumption, investment and net exports. What occurs is therefore merely a diversion of private demand towards public demand, rather than any real net rise in overall demand. Private sector demand is said to be ‘crowded out’ by public demand.

Alternatively, the government can also use expansionary monetary policy to reduce unemployment. Expansionary monetary policy occurs when the central bank increases the money supply. Interest rates will decrease and the cost of borrowing becomes cheaper. Households will find it cheaper to borrow to consume and firms will find it cheaper to borrow to invest. Both consumption and investment will rise. Since AD = C + I + G + (X-M), AD will increase and shift to the right thus reducing demand-deficient unemployment. Assuming the country has an open economy with a freely floating exchange rate system, the decrease in interest rate will cause the currency to depreciate. Currency becomes weaker and there will be hot money outflow. Exports become relatively cheaper while imports become relatively more expensive. Exports will increase while imports will decrease. Since AD = C + I + G + (X-M), AD will increase further and shift to the right further, hence, further reducing unemployment.

However, there are also limitations to expansionary monetary policy. One of the limitations is that consumption and investment are likely to be interest insensitive during a severe economic downturn as firms and households are unlikely to borrow when the economic outlook is very poor. Another limitation is the liquidity trap, which refers to the situation where interest rates are already so low such that the further cuts in interest rates are unlikely to have any impact in stimulating borrowing. At the extreme, when interest rates hit zero, this means that there is no more room for further interest rates cuts and expansionary monetary policy stops being viable.

In conclusion, it is not enough to use expansionary fiscal policy as the only way to reduce unemployment as there are many limitations to the policy. However, it will be best if both expansionary monetary and fiscal policy are used concurrently, so that the strength of one policy can overcome the weakness of the other. For instance, in a mild economic downturn, using monetary policy is arguably better than using fiscal policy as interest insensitivity has not set in and monetary policy is not affected by the crowding out effect. Whereas, in a deep recession, interest insensitivity is high and expansionary monetary policy generally loses its effectiveness. Hence, by using both policies concurrently, it will be able to reduce unemployment more effectively. 

JC Economics Essays - This is a H1 / H2 A levels economics essay paper response with a well developed and interesting answer. This is a very good effort. As good practice, the questions to ask yourself here are - what alternative approaches could you take to answering this economics question? This economics essay was also written under timed conditions, and so is not a complete response. What other arguments could be brought in to help bolster or counter-argue against the case? Think like an economics tutor critiquing and analysing the essay - what could be better improved, and why? 

Special thanks to HH for her kind and useful contribution, and also special thanks to SS for vetting and editing her response. HH has made great improvements in her economics  since 2015. Thanks for reading and cheers! 

Discuss monetary policy and fiscal policy’s importance for the USA, in the light of stagflation.

Introduction to Monetary and Fiscal Policy, and Stagflation

Monetary policy means to control the money supply and interest rates to affect aggregate demand (AD) in an economy, according to what is known as demand-management. Fiscal policy is another demand-management policy that deals with manipulating government spending and direct taxes so as to affect AD. Stagflation is defined as a situation of low economic growth with high inflation - both stagnation and inflation. Inflation is defined as a persistent and sustained increase in the general price level (GPL), that poses a problem to society because this increase in GPL is sustained and inordinate. 

This Economics paper discusses the strengths and limitations of monetary and fiscal policy, each in turn, in relation to stagflation in the USA. This paper concludes that both policies are equally important for the US, but they should be used in conjunction with supply side policy. 

Monetary Policy

Monetary policy works, in theory, by two ways. First, according to the classical direct transmissions mechanism, increases in money supply help consumers spend more and firms invest more directly because they have more money and they feel richer. Second, according to the indirect transmissions mechanism, increases in the money supply lower the interest rate, which lowers the cost of borrowing. Since it is cheaper for households to borrow money to consume, and cheaper for firms to borrow money to invest, C and I both increase, and since AD = C + I + G + (X-M), then AD increases, which helps to solve unemployment and which also causes actual economic growth. 

Unemployment is defined simply as the situation where people who are able and willing to work cannot find jobs, or they are unwilling to take up the jobs at the wage rate given to them. Actual economic growth merely refers to increases in real output at the macroeconomic level caused by increases in AD. Hence, it would seem that prima facie, monetary policy can help solve unemployment and lack of growth in the USA, and hence fight stagflation by countering the “stagnation” part.  

Limitations of Monetary Policy

However, monetary policy might suffer from the liquidity trap, which means that beyond a certain point interest rates cannot be lowered further, thus hampering the workings of monetary policy. If interest rates cannot be lowered, the costs of borrowing cannot be reduced. This can be seen in an analysis of the liquidity preference theory put forth by Keynes. 

Fiscal Policy

On the other hand, Keynesian fiscal policy works when governments spend more, for instance on national defence and education, or when they tax less, through lowering income and corporate taxes. Increasing G raises AD directly given that G is one of the components of AD. Lowering direct taxes cause C and I both to increase, and since AD = C + I + G + (X-M), then AD also increases, which helps to solve unemployment and which also causes actual economic growth. Because of the multiplier effect, where the multiplier means that national income increases by a factor more than the initial increase in the injections into the economy, the USA’s AD will increase, promoting and boosting growth. 

In the USA, both C and I are large components of the AD. It can also be argued that G is also a big component given that the USA has a large military. Hence, it would seem that prima facie, fiscal policy can also help solve unemployment and lack of growth in the USA, and thus fight stagflation by countering the “stagnation” part.  

Limitations of Fiscal Policy

However, there are also limitations to fiscal policy, one of which is the famous “crowding out effect”. If governments run a budget deficit, and the USA is arguably famous for running both a budget as well as a trade deficit for many years, then they will have to borrow money. According to the loanable funds theory, this increase in demand for funds by governments will crowd out private consumption and investment, and hence C and I will fall despite G increasing, thus negating the effects of fiscal policy. The US government would be “crowding out” private consumption and investment. 

Supply Side Policies?

Hence, supply side policies that target the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise, could be better for the USA in handling stagflation. Subsidies for energy and other natural resources, increases in the US labour force in both numbers and quality, for instance by increasing American high school education and human capital, and increases in both the quantity and quality of American capital, plus encouraging immigration especially of entrepreneurial foreigners, would help massively. 

These methods and means would shift the AS curve both down and to the right and help solve cost push inflation in the USA. These would be better because they would solve both the “lack of growth” and “high inflation” aspects. 

Conclusion

In conclusion, perhaps both demand side and supply side policies should be used hand in hand, and together they can help solve stagflation because they encourage both potential and actual growth, which is great for the American economy. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay on monetary policy and fiscal policy, set in the context of the USA, is interesting and provides a suitable level of analysis. There are consistent references to the USA as well as relevant macroeconomic policies, and the underlying economic reasoning behind those policies. There are also well-defined terms that are explained clearly. Note: this particular Economics essay on the USA is related to the earlier Economics question on stagflation: Explain possible causes of stagflation in the USA. However, my usual question applies here: if you were the Economics tutor grading this Economics paper, what areas of improvement would you suggest? Let's look, for example, at the conclusion. While this essay's conclusion makes a good argument and tries to justify the argument made, there is a lack of detailed evaluation which could possibly make it an even better essay. What other areas of improvement for this Economics essay do you observe or notice? Thanks for reading and cheers!

Explain possible causes of stagflation in the USA.

Explain possible causes of stagflation in the USA.

Introduction - Possible Causes of Stagflation in the USA

Stagflation, as the name suggests, refers to the macroeconomic situation of low economic growth and high inflation – stagnation and inflation occurring at the same time. The background to this essay is that from 2008-2010 due to the housing bubble crisis in 2007/2008 in the USA, there have been massive rates of unemployment, raising the jobless rate.

This Economics essay argues that the possible causes of stagflation in the USA can be traced to mainly cost-push inflation.

Cost Push Inflation?

First, general cost push inflation could have resulted in stagflation in the United States. Inflation can be defined as a sustained increase in the general price level (GPL), and it could be a problem when the increase in the GPL is sustained, persistent, and inordinate.

Inflation can be both demand pull and cost push, the first affecting the aggregate demand (AD) which equals consumption, investment, government spending, and net exports or C + I + G + (X-M), by shifting it to the right, and the second affecting the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise.

For cost push, increases in unit input costs in the factors of production will lead to the AS shifting upwards, lowering employment, and simultaneously raising the rates of inflation. This can be explained using the AD/AS diagram demonstrating cost push inflation.

For example, first, higher costs of inputs such as oil could have contributed to this situation, because oil is fast running out, and the demand for oil is relatively inelastic, which could lead to high volatility and high prices. Second, wage costs could possibly have spiralled in the USA. Third, capital costs could have increased, but this is highly unlikely given that this is the USA with its technological advantages and its huge supply of capital.

Imported Inflation?

Imported inflation, which generally also leads to cost push inflation, but can also lead to demand pull inflation in some instances, might not have been a major influence of stagflation in the United States. This is because while the USA might accuse China of artificially having low exchange rates, thus increasing their imports of Chinese goods and probably causing some unemployment in sunset industries in the USA, the decreasing AD that results from this situation would actually ease inflation, and not cause stagflation. 

Furthermore, the United States of America is a large country and does not depend on imported inputs that much for the production of her own products or exports. Possibly, the rise in global food and oil prices (commodity prices have been rising internationally) could lead to some imported inflation in the USA, which would have possibly also contributed to shifting the AS curve upwards, increasing GPL.

Quantitative Easing (QE)?

Second, excessive printing of money from the QE exercises (quantitative easing), from around 2008 to 2012, by the USA Federal Reserve (USA’s central bank) could have also led to stagflation in the USA because there could be the case of too much money chasing too few real goods. Also, it can be argued that according to the Fisher Equation, where MV = PT, increases in the money supply cause inflation to occur, corroborating Milton Friedman’s famous statement that “inflation is always and everywhere a monetary phenomenon”.

This might have contributed to the high inflation in the USA because low interest rates encourage borrowing for consumption and investment, which would have caused demand pull inflation to also occur; also, according to the classical direct transmissions mechanism, more money in the hands of consumers and firms would lead to higher C and I, thus boosting AD, which might have contributed to inflation. This could have led to AS shifting upwards due to asset bubbles, which raise the costs of production.

Conclusion

Hence, in conclusion, cost push inflation is likely to be the main cause of stagflation in the USA. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay is about the causes of low economic growth and high unemployment in the USA, and is clearly in reference to recent events, in recent years (around 2007 - 2012). There are many good points about this Economics essay, such as its references to Milton Friedman and the many excellent, relevant, real world examples. However, put yourself into the shoes of an Economics tutor - what would you say were the weaknesses of this Economics paper, and how would you remedy them? Other than the fact that an Economics diagram could have been used (the AD/AS diagram which is already highlighted and put in bold fonts in the essay), what else could have been done better? While this Economics paper is good, how can it be made even better? Thanks for reading and cheers!

Explain carefully what causes inflation [10]

Explain carefully what causes inflation. [10]

Inflation is a persistent and sustained increase in the general price level, or also defined by a persistent and sustained rise in the consumer price index. Inflation is caused by demand side factors or supply side factors, and these are called demand-pull inflation and cost push inflation respectively. A concatenation of increasing aggregate demand and rising costs cause inflation, although it is possible to have entirely demand pull inflation or cost push inflation. This paper discusses all these.

The AD-AS diagram below demonstrates demand pull inflation.

Insert diagram, AD-AS diagram: showing only demand pull inflation

AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports. If consumers spend more because of low interest rates encouraging borrowing, or if firms feel positive about future economic outlook, or if governments spend more money on military forces, or there is an export boom for local products exported overseas, then AD will shift to the right. Therefore, AD moves to AD’ and then AD’’, causing an upward shift in the general price level and therefore inflation, ceteris paribus. Hence, it is clear that excessive C, I, G or high exports with low imports will lead to demand pull inflation.

On the other hand, there is cost push inflation as well, where AS moves upwards from AS to AS’ and to AS”. This is demonstrated in the diagram below:

Insert AD-AS diagram showing cost push inflation

This is due to rising costs, and since the aggregate supply of goods and services in the economy is made up of various inputs, increases in the various inputs lead to rising costs. The supply of goods and services result from labour, capital, land and entrepreneurship. There are internal cost push factors. Rising wages or the rising power of trade unions demanding higher salaries, rising capital costs, and increasing scarcity of land and various input resources make cost push inflation a pertinent possibility. There are also external cost push factors. Exchange rates and the foreign sector can also lead to inflation if much of the goods produced use foreign inputs; hence there might be imported price push and exchange rate depreciations causing cost push inflation as well.

Thus, inflation can be caused by demand pull factors, cost push factors, or most probably and most conceivably, a combination of both. It depends on the particular situation.

JC ECONOMICS ESSAYS

PS Tutor's Note: Some Keynesian economists argue that it is primarily excess demand for goods and services that lead to such demand pull inflation, and other economists, namely the monetarists, claim that demand pull inflation is caused by excess money supply.

Tutor's Comments: A very well written essay! Well developed and relevant materials. Note: This economics essay paper was also written under examination conditions.