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!
