Economics Model Essay 11

Discuss whether fiscal policy is the best policy for decreasing demand-deficient unemployment. [25]

Answer

Introduction

Unemployment is the state of the economy where some people who are willing and able to work are not employed in the production of goods and services. Demand-deficient unemployment, or cyclical unemployment, refers to unemployment which occurs due to a deficiency in aggregate demand. Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. The question on whether fiscal policy is the best policy for decreasing demand-deficient unemployment can be discussed with reference to the effectiveness of expansionary fiscal policy, expansionary monetary policy and supply-side policies.

Body

Expansionary fiscal policy can be used to decrease demand-deficient unemployment. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. To decrease demand-deficient 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 demand-deficient unemployment. However, the use of expansionary fiscal policy to decrease demand-deficient unemployment is subject to several limitations. Changing government expenditure and taxation involves a high degree of inflexibility as fiscal budgets are subject to parliamentary debates and approvals which may take months. This is known as the decision time lag. An example is the United States where lawmakers often vote along party lines which hinders the passage of some fiscal budgets in the Congress. 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 and hence decrease in demand-deficient unemployment. An increase in government expenditure and a decrease in direct taxes due to expansionary fiscal policy are likely to lead to a budget deficit. If the government runs a budget deficit, it will borrow by issuing securities to finance the deficit, assuming it does not have sufficient reserves. When this happens, the public debt will rise. However, if the public debt-to-GDP ratio is high, a further increase in the ratio may induce people to lose confidence in the government’s ability to repay its debt which will cause the government to lose its ability to borrow. If this happens, the government will not be able to meet its debt obligations which will lead to a sovereign default. An example is Greece where the public debt-to-GDP ratio currently stands at over 170 per cent which makes expansionary fiscal policy virtually infeasible. A sovereign default will lead to a fall in aggregate demand resulting in a recession.

Expansionary monetary policy may be better than expansionary fiscal policy for decreasing demand-deficient unemployment. Monetary policy is a demand-side policy that is used to control the money supply and hence interest rates to influence aggregate demand. To decrease demand-deficient unemployment, the central bank can increase the money supply by conducting an open market purchase. When the money supply increases, the amount of reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to a fall in the level of interest rates in the economy. For example, the Federal Reserve increased the money supply to lower the federal funds rate from 5.25 per cent in October 2007 to 0-0.25 per cent in December 2008 to boost the faltering U.S. economy. Lower interest rates will decrease the incentive to save and the costs of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in demand-deficient unemployment. Expansionary monetary policy may be better than expansionary fiscal policy for decreasing demand-deficient unemployment due to several reasons. Unlike fiscal budgets, monetary policy decisions are not subject to parliamentary debates and approvals and hence the decision time lag of monetary policy is shorter than that of fiscal policy. Furthermore, as expansionary monetary policy works through decreasing interest rates, it will not lead to the crowding-out effect which is caused by a rise in interest rates. In addition, as expansionary monetary policy does not involve any increase in government expenditure or decrease in direct taxes, it will not cause a high public debt-to-GDP ratio to become even higher.

Expansionary monetary policy may not be better than expansionary fiscal policy for decreasing demand-deficient unemployment. Expansionary monetary policy is subject to several limitations which do not apply to expansionary fiscal policy. Although the central bank can decrease the level of interest rates in the economy, it does so indirectly through decreasing interbank rates by increasing the money supply. Therefore, when interbank rates are near zero, an increase in the money supply will not lead to a fall in interbank rates and hence the level of interest rates in the economy, as least not significantly. When this happens, consumption expenditure and investment expenditure will not rise, at least not significantly. This is known as the liquidity trap. An example is the United States where the federal funds rate was 0-0.25 per cent between December 2008 and December 2015. If investment is interest inelastic, a change in interest rates is unlikely to lead to a significant change in investment. An example is Singapore where a large proportion of investment expenditure is made by foreign firms with foreign sources of funds. Similarly, if consumption is interest inelastic, a change in interest rates is unlikely to lead to a significant change in consumption. An example is Singapore where there is a culture of thrift. A credit crunch is a situation where it is difficult to obtain credit due to a substantial decrease in the availability of credit from banks. Due to factors such as a rise in the default rate, banks may reduce lending which may lead to a credit crunch. If this happens, an increase in the money supply may not lead to a fall in interbank rates. Even if interbank rates do fall as a result of the increase in the money supply, the level of interest rates in the economy may not fall due to the decrease in the supply of loanable funds as banks tighten credit. Therefore, consumption expenditure and investment expenditure may not rise. In contrast, expansionary fiscal policy is not subject to the above limitations as it does not work through decreasing interest rates.

Supply-side policies may be better than expansionary fiscal policy for decreasing demand-deficient unemployment. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. For example, education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. A case in point is the setting up of the Institute of Technical Education, polytechnics and Continuing Education and Training campuses by the Singapore government to provide education and training. Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. The government can engage in research and development directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to engage in research and development. A case in point is the setting up of the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) by the Singapore government to engage in research and development. To decrease demand-deficient unemployment, the government can use supply-side policies to increase aggregate supply which will lead to an increase in national output and hence national income. Supply-side policies may be better than expansionary fiscal policy for decreasing demand-deficient unemployment due to several reasons. Although a small multiplier limits the effectiveness of fiscal policy, it does not limit the effectiveness of supply-side policies. Furthermore, although the use of expansionary fiscal policy to decrease demand-deficient unemployment will lead to higher inflation, the use of supply-side policies to decrease demand-deficient unemployment will lead to lower inflation. In addition, the use of supply-side policies to decrease demand-deficient unemployment will lead to potential economic growth which is essential for achieving sustained economic growth. In contrast, the use of expansionary fiscal policy to decrease demand-deficient unemployment may not lead to potential economic growth.

Supply-side policies may not be better than expansionary fiscal policy for decreasing demand-deficient unemployment. The effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Furthermore, although supply-side policies can be used to increase actual output, the effect will fall more on potential output than on actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may not rise, at least not significantly. Therefore, supply-side policies may not be effective for increasing actual output and hence decreasing demand-deficient unemployment. In contrast, the effectiveness time lag of expansionary fiscal policy is shorter and the effect on actual output is greater.

Evaluation

In the final analysis, the effectiveness of expansionary fiscal policy for decreasing demand-deficient unemployment depends to a large extent on the size of the economy. Large economies are more dependent on domestic demand than on external demand. For example, consumption expenditure alone in the United States accounts for about 70 per cent of aggregate demand. As expansionary fiscal policy increases consumption expenditure, investment expenditure and government expenditure on goods and services, it is likely to have a significant effect on national output and hence demand-deficient unemployment. In contrast, small economies are more dependent on external demand than on domestic demand. For example, domestic exports in Singapore account for a large proportion of aggregate demand. As expansionary fiscal policy does not increase exports, it may not have a significant effect on national output and hence demand-deficient unemployment. Although there are several policies to decrease demand-deficient unemployment, they are all subject to limitations, despite their strengths. To overcome this problem, the government should adopt a policy mix. The use of a policy mix allows the strengths of some policies to compensate for the limitations of other policies. This will eliminate their limitations and improve on their strengths resulting in greater effectiveness. Therefore, the use of a policy mix to decrease demand-deficient unemployment is likely to be more effective than the use of any single policy. For example, the use of expansionary monetary policy in conjunction with expansionary fiscal policy to decrease demand-deficient unemployment will help prevent the crowding-out effect.

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