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.
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