2011 Essay Question 4

Question

Discuss the extent to which conflicts between the macroeconomic goals of the government limit the scope for the use of fiscal policy to decrease unemployment. [25]

Answer

Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. The question on the extent to which conflicts between the macroeconomic goals of the government limit the scope for the use of fiscal policy to decrease unemployment can be discussed with reference to the effects on inflation, and the balance of payments, the state of the economy and the areas of increase in government expenditure on goods and services.

Expansionary fiscal policy can be used to decrease unemployment. To decrease unemployment, the government can increase expenditure on goods and services. For example, the Singapore government implemented the Resilience Package which included an increase in expenditure on infrastructure to increase economic growth in the 2008-2009 Global Financial Crisis. It can also increase disposable income to increase consumption expenditure by decreasing direct taxes such as personal income tax and corporate income tax or increasing transfer payments. In addition to an increase in consumption expenditure, a decrease in corporate income tax will lead to higher expected after-tax returns on planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

The use of expansionary fiscal policy to decrease unemployment may lead to high inflation and a persistent balance of payments equilibrium. An increase in aggregate demand will lead to a shortage of goods and services resulting in a rise in the general price level. Furthermore, when aggregate demand rises which will induce firms to increase production, the increase in the demand for factor inputs in the economy will lead to a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level and hence high inflation. If there are moderate to high inflationary pressures in the economy, a rise in inflation is likely to lead to high inflation. Therefore, the use of expansionary fiscal policy to decrease unemployment may conflict with the macroeconomic goal of low inflation. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. Furthermore, if a rise in inflation makes domestic goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. If the economy has a balance of payments equilibrium, a deterioration in the balance of payments will lead to a balance of payments deficit. Under the fixed exchange rate system, the balance of payments deficit will be persistent, other things being equal. Therefore, the use of expansionary fiscal policy to decrease unemployment may conflict with the macroeconomic goal of a balance of payments equilibrium.

The use of expansionary fiscal policy to decrease unemployment may not lead to high inflation and a persistent balance of payments equilibrium and it will not lead to low or negative economic growth. If there are no or low inflationary pressures in the economy, a rise in inflation may not lead to high inflation. Indeed, if there are deflationary pressures in the economy, a rise in inflation is likely to lead to low inflation which is desirable for the economy. Furthermore, the use of expansionary fiscal policy to decrease unemployment may lead to an increase in aggregate supply in the long run. For example, an increase in government expenditure on education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. An increase in the skills and knowledge of labour in the economy will lead to an increase in the production capacity in the economy resulting in an increase in aggregate supply. In addition, it will lead to an increase in labour productivity and hence a fall in the cost of production in the economy resulting in an increase in aggregate supply. If this happens, assuming aggregate demand is rising which is the normal state of the economy, the general price level will rise at a slower rate resulting in lower inflation. Therefore, the use of expansionary fiscal policy to decrease unemployment may not conflict with the macroeconomic goal of low inflation. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. However, if the economy has a persistent balance of payments surplus, a deterioration may help correct the surplus and hence achieve an equilibrium. Furthermore, if inflation falls, domestic goods and services may become relatively cheaper than foreign goods and services. If this happens, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. If the economy has a persistent balance of payments deficit, an improvement may help correct the deficit and hence achieve an equilibrium. Therefore, the use of expansionary fiscal policy to decrease unemployment may not conflict with the macroeconomic goal of a balance of payments equilibrium. Expansionary fiscal policy decreases unemployment through increasing aggregate demand and hence national output. Therefore, the use of expansionary fiscal policy to decrease unemployment may help achieve the macroeconomic goal of high economic growth.

The scope for the use of expansionary fiscal policy to decrease unemployment may be limited by other factors to a larger extent such as the inflexibility of government expenditure and taxation, the crowding-out effect, a small multiplier and a high public debt-to-GDP ratio. The crowding-out effect is the effect of an increase in government expenditure on goods and services resulting in a decrease in private expenditure. An increase in government expenditure on goods and services due to expansionary fiscal policy is likely to lead to a budget deficit. If the government runs a budget deficit, it will borrow by issuing securities (i.e. bonds and bills) to finance the deficit, assuming it does not have sufficient reserves. When this happens, the demand for loanable funds will rise which will lead to a rise in interest rates. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand. Therefore, the increase in government expenditure on goods and services may not lead to a significant increase in aggregate demand. An economy with high income taxes, high savings and high imports will have a small multiplier. For example, Singapore has a small multiplier due to the high savings and high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. If the multiplier is small, the initial increase in aggregate demand due to the increase in consumption expenditure, investment expenditure and government expenditure on goods and services may not lead to a significant increase in national output.

In the final analysis, among the factors which limit the scope for the use of expansionary fiscal policy to decrease unemployment, the most important among them varies from country to country and from situation to situation. For example, the public debt-to-GDP ratio in Greece currently stands at over 170 per cent. This high public debt-to-GDP ratio in Greece makes expansionary fiscal policy to decrease unemployment virtually infeasible, in spite of the high unemployment which is above 20 per cent. However, although Singapore also has a high public debt-to-GDP ratio, this is not a matter of concern due to the large amount of government reserves. In Singapore, the factor which limits the scope for the use of expansionary fiscal policy to decrease unemployment to the largest extent is the fact that it will not increase domestic exports which account for a large proportion of aggregate demand. If the cause of high unemployment is a result of a decrease in aggregate demand, the resultant deflationary pressures are likely to prevent the use of expansionary fiscal policy to decrease unemployment from leading to high inflation. For example, the use of expansionary fiscal policy by the U.S. government to decrease unemployment in the 2008-2009 Global Financial Crisis did not lead to high inflation as the crisis occurred due to a decrease in aggregate demand. However, in the event that high unemployment occurs due to a rise in the cost of production in the economy and hence a decrease in aggregate supply, the use of expansionary fiscal policy to decrease unemployment is likely to lead to high inflation due to the presence of moderate to high inflationary pressures.

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