Readers Question: Is the fiscal policy effective/the best policy to deal with unemployment?
It is an interesting question, and one that is likely to generate different views from within the ranks of Economists.
To give a very rough overview:
- Keynesians say yes, fiscal policy can be effective in reducing unemployment. In a recession, expansionary fiscal policy will increase AD, causing higher output, leading to the creation of more jobs.
- Classical Economics say no. Fiscal policy will only cause a temporary increase in real output. In the long run, expansionary fiscal policy just causes inflation and does not increase real GDP. Classical economists argue that to reduce unemployment it is necessary to use supply side policies which increase the flexibility of labour markets (e.g. reducing power of trades unions)
So who is Right?
In a way I find the distinction between Keynesian and Classical economists rather artificial. I believe that under certain circumstances both can be right.
Firstly, I do believe that fiscal policy CAN reduce cyclical unemployment. In a recession, cutting taxes and increasing government spending can increase AD, and this injection into the economy is likley to create jobs.
Note: fiscal policy has many limitations such as:
- crowding out (government borrowing reduces size of private sector)
- Tax cuts may be saved not spent
- Time Lags
- See: Criticism of fiscal policy for more details
However, despite these limitations it can play a role in increasing AD and reducing cyclical unemployment.
Can Fiscal Policy Solve Unemployment?
No, fiscal policy cannot solve supply side unemployment. If there is frictional or structural unemployment, fiscal policy will not solve this. For example, suppose some former miners are unemployed. The problem here is lack of skills and geographical immobilities. Therefore, what is needed is supply side policies. Increasing AD and economic growth does not solve the mismatch of skills. Therefore, when the economy is at full capacity Classical economists are correct. My criticism of the classical model is that in the long run the economy always reaches full output, this is not the case.
Does Fiscal Policy Cause Inflation.
If you increase AD, it could cause inflation. In a recession, when there is spare capacity inflation is unlikely to be a problem. However, if AD increases too much, when the economy is close to full capacity then it will cause inflation.