INTRODUCTION

CLASS 11: UNEMPLOYMENT AND FISCAL POLICY

ADAPTED FROM THE COURSE SLIDES AND CORE ECON MATERIALS

PROFESSOR: BRUNO PESSOA CARVALHO

Principles of Economics, 2023/24

UNEMPLOYMENT AND FISCAL POLICY
INTRODUCTION

▪ In the last class, we discussed how aggregate demand (GDP) may fluctuate due to:
▪ Consumption and investment decisions (Unit 13)

▪ Fluctuations may bring important economic and social costs and so it is important to understand what forces can mitigate
them. We already discussed that:
▪ Consumption smoothing plays a role, but credit constraints may dampen the stabilization induced by consumption;
▪ Investment, in turn, is even more volatile than GDP.

▪ In this class, we study how governments, using fiscal policy, can help dampen economic fluctuations:
▪ How can the government stabilize the economy?
▪ Why might some government policies be ineffective? Fiscal Policy comprises
▪ How can me model the link between output and unemployment? tax and government
spending policies.

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UNEMPLOYMENT AND FISCAL POLICY
INTRODUCTION

▪ The graph plots the evolution of GDP growth and

government size for the US:

𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
▪ 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑖𝑧𝑒 = 𝐺𝑟𝑜𝑠𝑠 𝑁𝑎𝑐𝑖𝑜𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡

[Gross Nacional product is a measure of a country’s

output produced, domestically or abroad, by national
residents.]

▪ Government size is relatively stable across time and plays

an important role in stabilizing in the economy.

▪ In some periods, Government size moves:

▪ in the same direction of GDP;
▪ In others, in the opposite direction.

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AGGREGATE DEMAND AND THE MULTIPLIER MODEL
INTRODUCTION

▪ In the next slides, we discuss the components of aggregate demand (AD):

Private Private
Government Net exports
Consumption Investment

▪ We have already seen how they can be used to measure economic activity and the GDP (spending approach);

▪ We now study each component further and discuss how we can combine them to study the several ways in which
government action can induce output stabilization.

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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) CONSUMPTION FUNCTION

▪ We assume Private Consumption has two components:

𝐶 = 𝑐0 + 𝑐1 𝑌

Autonomous consumption Induced consumption

(independent of income) (proportion of income)

▪ Induced consumption varies with current income.

▪ 𝑐1 is the slope of the consumption function, or the
marginal propensity to consume (MPC):
▪ Typically, 0 < 𝑐1 < 1;

▪ MPC differs across people:

The portion of
▪ Poor households react a lot to changes in current income [large MPC] → credit constraints;
! income not
▪ Wealthy households’ current consumption reacts less to current income [small MPC].
consumed is
▪ Expectations about future income are reflected in autonomous consumption.
saved: 1 − 𝑐1
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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) CONSUMPTION FUNCTION: HOUSEHOLD WEALTH

▪ Household wealth affects autonomous consumption, and has several components:

▪ For homeowners, the value of the house is part of wealth Broad wealth = Broad assets - debt

▪ If the house was purchased with a loan:

▪ Outstanding loan value is not part of wealth;
▪ Home equity is the difference between the value of
the house and the outstanding debt;

▪ Savings and other investments constitute financial wealth;

▪ Expected future earnings from employment are also part of

wealth in a broad perspective.

▪ Target wealth is the level of wealth a household aims to hold,

based on economic goals (preferences and expectations)

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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) CONSUMPTION FUNCTION: HOUSEHOLD WEALTH

▪ Shocks to household wealth may induce changes in consumption.

▪ Suppose before the 1929 crisis households in the US had a broad wealth as described in column A.

▪ With the 1929 crisis:

▪ Value of houses declined (Home equity ↓)
▪ Savings and investment value reduced (Financial Wealth ↓)
▪ Downward revision of (expected) future earnings.

▪ As a result, Broad wealth is in column B below target wealth.

▪ Households are likely to increase savings to restore wealth to

target level – precautionary savings;

A fall in expected earnings leads to a cut in (autonomous) !

consumption (precautionary savings) to restore target wealth.
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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) CONSUMPTION FUNCTION: HOUSEHOLD WEALTH

▪ A large shock to wealth may also affect consumption through other channels. On of these are the changes in house prices.

▪ A decline in home equity directly reduces Broad

wealth;
▪ This incentivizes precautionary savings and, thus,
a reduction in consumption.

▪ Lower home equity also increases credit constraints:

▪ If your main asset is worth less, you are likely
going to find it harder to borrow.
▪ Greater credit constraints limit current
consumption.

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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) INVESTMENT FUNCTION

▪ We assume investment is autonomous (does not depend on income).

Investment increases with: !
▪ The profits of a firm’s activity can be: ▪ Lower interest rate [demand-
▪ Distributed by the owners and used for private consumption or savings; side factor];
▪ Invested in production activity (either in own or another firm). ▪ Higher expected rate of profit
[supply-side];
▪ The level of investment in the economy depends on:
▪ Improvements in business

Owner’s discount Interest rate on Net profit rate on environment, e.g. low risk of
rate (𝜌) assets (𝑟) investment (Π) expropriation [supply-side].

▪ If:
𝜌 > 𝑟 ≥ 𝛱 Owner discounts future consumption a lot, so consume extra income (dividends). Less
𝑟 > 𝜌 ≥ 𝛱 Interest rate is high, so save extra income or repay debts. investment
Return from investment is high, so invest profits in further production activity (own More
𝛱>𝜌≥𝑟
or another firm, at home or abroad). investment
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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
(PRIVATE) INVESTMENT FUNCTION

▪ The aggregate investment function shows how investment depends on interest rate and profit expectations.

▪ Investment is negatively correlated with interest rates (𝑟):

▪ Investment curve is downward slopping;
▪ If 𝑟 = 4%, level of investment is lower than if 𝑟 = 3%.

▪ If profit expectations (𝜫) are high, investment function

shifts to the right:
▪ For the same interest rate (𝑟 = 4%) investment is
higher.
▪ Rightward shifts can be caused by: Empirical evidence shows investment is mostly
▪ Fall in input prices (energy costs/wages), determined by shift factors. Changes in the interest
rate affect investment mostly indirectly (through
improvements in technology, lower taxation, etc. ! changes in consumption of durables).
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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
GOODS MARKET EQUILIBRIUM (I)

▪ A simplified aggregate demand model comprises both consumption and investment: When 𝑌 = 𝐴𝐷 we say goods
𝐴𝐷 = 𝐶 + 𝐼 = 𝑐0 + 𝑐1 𝑌 + 𝐼 = 𝑐0 + 𝐼 + 𝑐1 𝑌
! market is in equilibrium
(production equal to demand)
Intercept: autonomous
consumption and
investment

▪ 45o line represents the points where 𝑌 = 𝐴𝐷;

▪ Thus, the equilibrium of the model is obtained where AD

curve intersects the 45o line (point A):

𝒀 = 𝑨𝑫

▪ Notice that:
▪ Slope of 45o line is 1;
▪ Slope of AD is <1, because 𝑀𝑃𝐶 = 𝑐1 < 1.
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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
GOODS MARKET EQUILIBRIUM (I): MULTIPLIER EFFECT

▪ The aggregate demand model features an important multiplier effect:

𝑌 = 𝐴𝐷 = 𝑐0 + 𝐼 + 𝑐1 𝑌
▪ Goods market is initially in equilibrium at point A;

▪ Suppose investment falls [𝐼 → 𝐼′]:

▪ Aggregate demand declines [AD shifts downwards]
▪ At the old production level, 𝐴𝐷 < 𝑌, so point B is
not an equilibrium;

▪ Output/income declines to 45o line [B→C];

▪ But for this output level we still have 𝐴𝐷 < 𝑌, so
output/income decline further [D→E]

▪ The process continues until we reach Z, the new

Multiplier effect: Investment fell €1.5bn and output fell
equilibrium.
! €3.75bn (multiplier=2.5)

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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
GOODS MARKET EQUILIBRIUM (I): MULTIPLIER EFFECT

▪ Due to the multiplier effect, the total change in output stemming from a change in aggregate demand can be higher than
the initial change in the demand:
▪ This is because of the circular flow of expenditure, income and output.

▪ GDP (Y) and AD move in the same direction, the multiplier represents the relative magnitude of the movement:

Multiplier>1 Change in AD leads to a more than proportional change in GDP.

Multiplier=1 Change in AD leads to a proportional change in GDP.
Multiplier<1 Change in AD leads to a less than proportional change in GDP

▪ What determines the size of the multiplier in our simplified AD model?

▪ The slope of the AD curve, i.e., the marginal propensity to consume;
▪ Credit constraints and consumption smoothing preferences affect MPC [e.g. poor vs. wealthy households]

▪ Shifts in AD can be caused by changes in MPC or the autonomous components [consumption and investment]

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BASIC AGGREGATE DEMAND MODEL AND THE MULTIPLIER
GOODS MARKET EQUILIBRIUM (I): THE 1929 CRISIS

▪ We now use this simplified AD model to illustrate the effects of the 1929 crisis:

▪ Before the crisis GDP was 324 bn (Q3, 1929):

▪ Where brown AD crosses 45o line [point A].

▪ With 1929 stock market crash, low investment led to

▪ Aggregate demand fall;
▪ New equilibrium with lower output/income [point B];
[drop in GDP is more than proportional: multiplier>1]

▪ In face of lower income, AD fell even more due to:

▪ Drop in consumption and further drop in investment:

▪ This was caused by high uncertainty due to stock market crash, pessimism, banking crisis and collapse of credit.
▪ New equilibrium output 206bn [Point C], again multiplier > 1.

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EXPANDED AGGREGATE DEMAND MODEL AND THE MULTIPLIER
INTRODUCING GOVERNMENT AND EXTERNAL TRADE IN THE MODEL

▪ We now make the AD model more comprehensive by introducing the government (𝐺) and external trade (𝑁𝑋).

𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

▪ Government enters AD in three ways: ▪ External trade enters the AD in two ways:
▪ Government spending (𝐺): autonomous (exogenous ▪ Exports (𝑋): are taken as exogenous and shift AD
component), shifts AD upwards; upwards;
▪ Consumption (𝐶): Income taxation (𝑡) reduces ▪ Imports (𝐼): assumed to be proportional to
disposable income and induced consumption income
▪ 𝐶 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑌 ▪ 𝐼 = 𝑚𝑌
▪ Investment (𝐼): depends on interest rate and shit ▪ Marginal propensity to import (𝑚): measures
factors (corporate taxes, business environment) the fraction of each additional unit of income
▪ High interest rate or tax rate reduce autonomous spent on imports.
investment.

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EXPANDED AGGREGATE DEMAND MODEL AND THE MULTIPLIER
GOODS MARKET EQUILIBRIUM (II): MULTIPLIER EFFECT

▪ Given all the components discussed so far, AD model is now:

𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 = 𝑐0 + 𝑐1 1 − 𝑡 𝑌 + 𝐼 + 𝐺 + 𝑋 − 𝑚𝑌
= 𝑐0 + 𝐼 + 𝐺 + 𝑋 + 𝑐1 1 − 𝑡 − 𝑚 𝑌

Autonomous components Endogenous components

(y-intercept): 𝑐0 , 𝐼, 𝐺, 𝑋 (slope/multiplier): 𝑐1 1 − 𝑡 𝑌, 𝑚𝑌

▪ Saving, taxation and imports are referred as leakages from the circular flow of income:
▪ They reduce the size of the multiplier:
▪ 𝑐1 : how much of income goes to consumption and savings;
▪ If 𝒄𝟏 is low, or 𝒕/𝒎 are high:
▪ 𝑡: how much of income goes directly to the government as taxes;
▪ The AD curve is flatter;
▪ 𝑚: how much of income is used to buy goods from abroad
! ▪ The multiplier is smaller.

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FISCAL POLICY IN THE AGGREGATE DEMAND MODEL
STABILIZING ROLE OF THE GOVERNMENT

▪ The government stabilizes economic fluctuations in several ways:

Higher tax rate lowers the Unemployment insurance

Government Deliberate
multiplier helps consumption smoothing
spending is large and intervention via
[reduces disposable income (Unemployment can be seen
exogenous fiscal policy changes.
and so induced consumption] as failure of private markets)

▪ Importantly, unemployment benefits and proportional tax rate are known as automatic
stabilizers;
▪ They automatically offset expansion or contraction of the economy;
▪ Proportional tax rate penalizes more high levels of income, reducing induced
consumption in booms more;
▪ Unemployment benefits reduce drop in income in case of recession.

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FISCAL POLICY IN THE AGGREGATE DEMAND MODEL
A NOTE: PARADOX OF THRIFT

▪ In a recession, faced with household budget deficit, a family worried about falling wealth cuts spending and saves more;

▪ However, in the economy as a whole, spending and earnings go together:

▪ If consumption drops, so does firms’ output;
▪ This likely translates into lower investment and employment;
▪ And further reduction of household income and consumption.

▪ Paradox of thrift: the aggregate attempt to increase savings leads to a fall in aggregate
income.

▪ The paradox of thrift is an example of the Fallacy of composition:

▪ What is true for one part of the economy (a single household) is not necessarily true for the whole economy.

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FISCAL POLICY IN THE AGGREGATE DEMAND MODEL
FISCAL STIMULUS

▪ In a recession, Government can counteract the fall in AD from the private sector via fiscal stimulus:
▪ This is a discretionary change in fiscal policy – counter-cyclical policy.

▪ Two examples:
▪ Increase spending (↑ 𝐺) – Direct effect;
▪ Cut taxes (↓ 𝑡): to encourage private spending – Indirect
effect.

▪ Suppose economy is initially at point A and:

▪ Autonomous consumption falls (𝑐0 → 𝑐0′ )
▪ Equilibrium output drops to point B.

▪ If government increases spending (𝐺 → 𝐺′), AD shifts upward:

Due to the multiplier change in government spending
▪ Equilibrium output/income increase to point C
▪ 𝑌𝐵 < 𝑌𝐶 < 𝑌𝐴 .
! induces a more than proportional change in output.

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FISCAL POLICY IN THE AGGREGATE DEMAND MODEL
FINANCING A FISCAL STIMULUS

▪ Governments fiscal stimulus packages require higher spending (or lower revenue), which penalizes government budgets;

Government budget…
Surplus Revenue > Expenditure
Balance Revenue = Expenditure
Deficit Revenue < Expenditure

▪ In our simplified set-up, government:

▪ Revenue stems from income taxes collected (T)
Budget balance = T − G
▪ Expenditure stems from Government spending (G)
▪ If G and T increase at the same time, the stimulus is small or inexistent.
!
▪ Thus, in general government stimulus generates a deficit, that can be funded by public debt: This may make it harder
▪ If deficit is temporary, it is not problematic; for government to lead
▪ Persistent deficits will generate an increasing public debt level; with future crises.
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FISCAL POLICY IN THE AGGREGATE DEMAND MODEL
AUSTERITY POLICY

▪ In a recession, Government deficit is likely to increase due to the automatic stabilizers:

▪ Tax revenue will decrease because output is lower;
▪ Unemployment benefits are likely to increase.

▪ If the Government is strapped by high levels of public

debt:
▪ Stimulus policies may not be possible;
▪ May be unsustainable if cost of debt is too high.

▪ As a result, Government may be forced to implement

austerity policy [Equilibrium point C]:
▪ ↓ 𝐺 or ↑ 𝑡;
▪ This will lower AD even more (𝑌𝐶 < 𝑌𝐵 < 𝑌𝐴 ).
Due to the multiplier drop in government spending

▪ In this context, this is a pro-cyclical policy. ! induces a more than proportional drop in output.

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MULTIPLIER IN REAL LIFE
ESTIMATING THE SIZE OF THE MULTIPLIER

▪ In the model of AD we have been discussing, the multiplier depends only on:
▪ Marginal propensity to consume (𝑐1 );
▪ Marginal propensity to import (𝑚); Slope of AD curve.

▪ Income tax rate (𝑡)

▪ In reality, the multiplier is affected by a multitude of other factors, e.g.:

▪ Rate of capacity utilization [phase of business cycle]:
▪ With fully employed resources [boom] increases in government spending can crowd out private spending;
▪ Expectations of the private sector:
▪ The multiplier could be even be negative if rising fiscal deficit erodes consumer/business confidence:
▪ Deficits may be funded with debt, but debt means higher future taxes/lower future spending

▪ There is substantive literature investigating the (direction and) size of fiscal multiplier:
▪ Question: What is the impact of fiscal policy on output?

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MULTIPLIER IN REAL LIFE
ESTIMATING THE SIZE OF THE MULTIPLIER

▪ The main problem of addressing this question is a common one in economics research, endogeneity:
▪ Say we observe government spending and output are positively correlated;
▪ Can we infer that changes in government spending lead to changes in output?
▪ Not necessarily: change in government spending may be the result of changes in output – reverse causality.

▪ One interesting study that addresses this issue is Acconcia, Corsetti and Simonelli (2014):
▪ In Italy, local governments infiltrated by the Mafia are dismissed and replaced by technocrats:
▪ 199 city council dismissals unrelated to local economic activity;
▪ Following dismissal, local government spending declines:
▪ No reverse causality here – dismissal not related to local economic activity.
▪ Still, 1% drop in government spending leads to 1.5% decline in local GDP:
▪ Positive relation between government spending and GDP!

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GOVERNMENT FINANCES
DEFICIT AND DEBT

▪ It is useful to distinguish between two concepts of deficit:

Difference between government spending and revenue (G-T),
Primary budget deficit
excluding interest rate expenditure on debt.
Difference between overall spending and revenue
Total budget deficit
(Interest Expenditure + Government spending – Revenue)

▪ Total outstanding government debt is the sum of all bonds sold over time to finance budget deficits:
▪ Bonds can be issued with different maturities: short (<5 years) to long (>=5 years) –term;
▪ Matured bonds are debt that has already been paid.
▪ Price of bonds is the interest rate [measure of risk] investors are willing to pay to hold the bond.

▪ A large stock of debt (measured, for instance by debt-to-GDP ratio) may be problematic. Default risk perception increases:
▪ There is, however, no point at which all the stock of debt has to be repaid – government can issue new bonds.
▪ An ever-increasing debt-to-GDP ratio is unsustainable, but there is no rule that determines a specific limit.

▪ Sovereign debt crisis is a situation in which government bonds come to be considered (very) risky.

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GOVERNMENT FINANCES
DEBT-TO-GDP RATIO

▪ The evolution of debt-to-GDP ratio for the UK since 1700 is shown in the figure:
Government Debt
Debt − GDP ratio =
▪ We generally measure the level of indebtedness relative to GDP

the size of the economy (debt-to-GDP ratio):

▪ It is natural a smaller country like Luxembourg has a
lower total debt than Germany.
▪ So, what matters the most is the relative size of the
debt.

▪ Indebtedness measured by debt-to-GDP ratio can fall if:

▪ Primary budget balance is positive (surplus can be
used to repay debt). Bonds are repaid at face value. If you borrowed $1000
▪ GDP is growing faster than government debt; in 1980 and have to repay it 2020, money has lost
▪ Inflation is high (real value of debt falls). ! value due to inflation, but you still pay $1000.

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AGGREGATE DEMAND MODEL: FEEDBACK MECHANISMS
PRIVATE SECTOR, GOVERNMENT ACTIONS, AND OUTPUT (DE-)STABILIZATION

▪ Overall, both the private sector and government

decisions may induce output stabilization;

▪ This is crucial to avoid very large booms, and

deep recessions;

▪ In general, the government aims to have a

stabilizing role, however policy mistakes, e.g.:
▪ Too strict unemployment benefits access
restrictions;
▪ Systematic budget deficits

▪ Can limit the tools the government can use to

stabilize output [e.g. austerity in recession].
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AGGREGATE DEMAND MODEL: CONNECTION WITH UNEMPLOYMENT
LABOUR MARKET AND MULTIPLIER MODELS

▪ We can think about aggregate unemployment in two perspectives:

In the medium-run: In the short-run:

▪ Wages and prices are flexible; ▪ All variables are fixed;
▪ But capital stock, technology and
institutions are fixed;
▪ This is the labour market model ▪ This is the multiplier
→ supply-side model → demand-side
[model from Class 8, Unit 9]
The production function connects employment (N) and output (Y).

▪ Fluctuations in AD around the labour market equilibrium cause cyclical

unemployment – neither Wage nor price-setting curves change in SR!

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SUMMARY
UNIT 14

▪ In this class, we:

1. Presented the aggregate demand function and its components:
▪ 𝑨𝑫 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

2. Shocks to aggregate demand are amplified by the multiplier;

3. Government can stabilise economic fluctuations:

▪ Automatic stabilisers (progressive taxes and unemployment benefits);
▪ Fiscal stimulus: offset decline in aggregate demand from a shock that affected the private sector;
▪ Austerity policies amplify the negative demand shock.

4. Fiscal stimulus in a recession must be reversed in a boom to prevent government debt from escalating:
▪ During foreign debt crisis (like the one in Europe in 2010) investors fear that governments cannot repay debt;
▪ This can reduce the possibility of implementing future fiscal stimulus packages and lead to large domestic crisis.

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REVIEW QUESTIONS
UNIT 14

1. The graph depicts a consumption function of an economy, where C is the

aggregate consumption spending and Y is the current income of the economy. Based
on this information, which of the following statements is correct?
A) The marginal propensity to consume (MPC) is the proportion of current income
spent on consumption, C/Y.
B) The MPC is given by the line’s intercept on the vertical axis.
C) The MPC is normally less than 1 as some households are able to smooth their
consumption.

2. Which of the following statements is correct?

A) Maintaining fiscal balance in a recession helps to stabilize the economy.

B) Automatic stabilizers refer to the fact that economic shocks are partly offset by households smoothing their
consumption in the face of variable income..
C) A fiscal stimulus can be implemented by raising spending to directly increase demand, or by cutting taxes to
increase private sector demand.

▪ Answers: C; C
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