Fiscal Policy to Achieve Full Employment

Suppose our economy's full-employment output is $700 billion. With our present equilibrium of $640 billion, there is a recessionary gap of $60 billion: the economy is experiencing unemployment.

According to the Keynesian model, the source of the problem is too little spending. One corrective approach is the use of discretionary fiscal policy. The appropriate policy response is to increase government spending or reduce taxes (or effect some combination of the two). Let's consider these alternatives.

If government spending is increased while taxes remain unchanged, the amount of total spending in the economy will increase. More spending for goods and services means that businesses will be justified in increasing their production, which will create more jobs.

We must use our knowledge of the multiplier to determine how much more government spending will be necessary. The multiplier in our hypothetical economy is 4; therefore, every additional dollar that the government spends will ultimately produce a $4 increase in total spending and equilibrium output. If we wish to increase GDP by $60 billion, government spending must be increased by $15 billion ($60 billion + 4 = $15 billion). Exh. A.3 shows that a $15 billion increase, when expanded by a multiplier of 4, will produce the needed $60 billion increase in GDP and permit our hypothetical economy to achieve full employment. In an economy with a multiplier of 2, the government would have to increase spending by $30 billion to achieve the same $60 billion increase in GDP. (Recall that studies show the value of the multiplier in the U.S. economy to be approximately 2.)

The goal of full employment can also be pursued by cutting taxes and leaving government spending unchanged. If taxes are reduced, consumers

EXHIBIT A.3. Expansionary Fiscal Policy

Expansionary Fiscal Policy

are left with more disposable income, which enables them to increase their consumption spending. This increase in the demand for consumer goods stimulates producers to increase their output and creates additional jobs. Determining the precise amount of a tax reduction to combat unemployment is more complicated than determining the right amount to increase government spending. When taxes are reduced, consumers will not spend all of the additional disposable income the reduction provides; they will save some portion of their increased income.

We saw that $15 billion in increased spending was sufficient to raise equilibrium by $60 billion and eliminate the recessionary gap. By what amount must we reduce income taxes to prompt consumers to spend an additional $15 billion? If the MPC is 0.75, taxes must be reduced by $20 billion (0.75 x $20 billion = $15 billion).5 Because consumers will spend 75 percent of any increase in disposable income, a tax reduction of $20 billion will lead to a $15 billion increase in consumption spending and, through the multiplier, a $60 billion increase in equilibrium GDP. Because not all of it will be spent, a tax reduction used to stimulate spending and promote full employment must be somewhat larger than the increase in government spending that would accomplish the same objective.

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