Does Fiscal Policy Solve Unemployment?

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.

Related:

9 Responses to Does Fiscal Policy Solve Unemployment?

  1. ow March 5, 2009 at 4:36 pm #

    in the modern society and current economic situation there is no room for classic economists and therefore it is neccessary to take the optimistical view that FP does reduce unemployment no matter how theoretical that answer is.

  2. lezzyn October 12, 2009 at 2:01 pm #

    what impact or effect does fiscal expansionary policy have on the fishing sector?

  3. Apoorva Marathe November 18, 2009 at 7:08 am #

    Use of fiscal policy to solve unemployment problem in countries like India requires a different kind of treatment in the sense that the quality of money spent by the government is important. The quantity or size and no of spending programes have increased but they have not reached the people who deserve it. A holistic approach of socio-political implications and involvement along with economic implications of fiscal policy become essential. Along with the national the subnational finances play critical role in doing so.

  4. Lowel Bolin February 17, 2010 at 10:39 pm #

    There is an easy way to reduce unemployement…reduce capital gains and business tax. This reduces the risk side of the equation for those looking to start / expand their business and thus generates business expansion and jobs. Problem is this is seen as a tax cut for the wealthy…

  5. Jennifer March 18, 2010 at 8:46 pm #

    from my point of view, i believe fiscal policy can reduce unemployment conversely, it also has its bad sides which sometimes overshadow its usefulness in solving unemployment.

    • hemant February 2, 2012 at 10:39 am #

      its looks like that it reduce unemployment if we look on Keynesian grafs . but when ad curve increases the effect on wages will increase which give the feed back to increase in money demand consequently increase in the rate of interest which will hurt the future investment and unemployment increases by the fiscal policy . monetary policy has always win win situation , by increasing supply of money rate of interest will reduces and feed back of this it increases investment (if there is not liquidity trap) and consequence will be generation of employment.

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