Reducing the Unemployment Rate

Readers Question: HI, i want 2 knoe that how wiil help the fisical policy 2 decrease the unemployment?

Fiscal policy involves changes to the level of government spending and tax to influence Aggregate Demand.

There are two components to fiscal policy.

Firstly, there are the automatic fiscal stabilisers.
In a recession, tax receipts fall and government spending on unemployment benefits increase. This helps to minimise the fall in AD. But, on its own the automatic stabilisers may be insufficient to boost spending and get the economy out of a recession. (especially in a country like US, where unemployment benefits are lower than in Europe. Europe has a bigger automatic stabiliser effect than in US)

Discretionary Fiscal Stabilisers occur when the government change the rate of tax or levels of government spending in order to deliberately effect Aggregate Demand.

For example, the UK cut the rate of VAT from 17.5% to 15%. It was hoped this temporary tax cut would increase spending. It should increase spending for two reasons.

  • Goods will be cheaper encouraging people to buy more. (especially big ticket items like Flat screen TVs)
  • Because goods are cheaper, consumers have an effective increase in income. Their income goes further now goods are cheaper so they can buy more.

Also, because the tax cut will expire, in theory, people should buy now before prices rise again next year.

In a recession, people often become very risk averse and rather than maintain normal spending patterns they try to pay off debt and increase savings. However, when everyone saves at the same time it can cause a substantial fall in demand and therefore firms end up laying off many workers.

However, if tax cuts can encourage spending, firms will have more orders and therefore will hire more workers. This increase in aggregate demand should reduce unemployment.

However, given the scale of the recession, the tax cuts may be insufficient to reduce unemployment. Also, there may be significant time lags before the expansionary fiscal policy works.

Another problem is that fiscal policy leads to a large rise in government borrowing. Some economists argue this is a very serious problem and the government borrowing will crowd out the private sector – leading to no overall increase in AD. However, in a recession, crowding out rarely occurs because government borrowing is merely offsetting a rise in private sector saving.

More evaluation on this question can be found at

By on September 10th, 2009

One thought on “Reducing the Unemployment Rate

  1. My hunch is that the 2nd last para above makes a good point, i.e. “crowding out rarely occurs because government borrowing is merely offsetting a rise in private sector saving”. However, while this is true in a recession caused by increased private saving, this point loses some force in the current recession in that the latter has been caused by the EXTINGUISHING of private bank created money (as distinct from central bank created money: the monetary base). I.e. the recession has been caused no so much by increased saving (though the latter IS taking place), as by the extinguishing of savings.

    See the following for a detailed explanation of this point:

    This leads to a closely related and more general point. There is uncertainty in the economics profession as the exact effects of increased government borrowing and spending, as is correctly suggested in the above article.

    I suggest there is a simple solution to this problem: spend without borrowing ! I.e. where an economy needs a boost, just print money and spend it.
    Printing EXACTLY the right amount – so as to bring reasonably full employment without inflation – is difficult. If too much is printed and inflation looms, then government would need to take deflationary measures, e.g. raise taxes, borrow more, increase interest rates, etc.

    So why don’t we do the latter? Is it that taking the latter deflationary measures, when needed, could not be effected quick enough?

    Others with views on this topic are as follows. The German Finance minister rubbished the British VAT reduction a year or so ago. See article by Paul Krugman (economics Nobel laureate) on this:

    Warren Mosler makes a novel point here, namely that “borrow and spend” works (as I understand his point) because it increases net financial assets in the hands of the private sector. To illustrate: 1, government borrows £x and spends it, 2, money in the hands of the private sector remains the same, because the money that govt borrowed is returned to the private sector because of the increased govt spending, 3, net result is that the private sector has £x of govt bonds it didn’t have before !

    Moslers site is:

    I criticise his ideas on this site, and he gives me a bo***cking for doing so! Great subject economics: there’s always someone to quarrel with.

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