THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
21: Innovation
22: Politics and policy
UNIT 14
UNEMPLOYMENT AND
FISCAL POLICY
HOW GOVERNMENTS CAN MODERATE COSTLY
FLUCTUATIONS IN EMPLOYMENT AND INCOME
• Fluctuations in aggregate demand affect GDP growth through a
multiplier process, because households face limits to their ability to
save, borrow, and share risks.
• An increase in the size of government following the Second World
War coincided with smaller economic fluctuations.
• Governments can use changes in taxes or government spending to
stabilize the economy, but bad policy can destabilize it.
• If a single household saves, its wealth necessarily increases, but if all
households save this may not be true, because without additional spend-
ing by the government or firms to counteract the fall in demand,
aggregate income will fall.
• Every national economy is embedded in the world economy. This is a
source of shocks, both good and bad, and places constraints on the kinds
of policies that can be effective.
In August 1960, three months before he was elected US president, the
43-year-old Senator John F. Kennedy found time to spend the day cruising
Nantucket Sound on his boat, the Marlin. His crew for the day included
John Kenneth Galbraith and Seymour Harris, both Harvard economists,
and Paul Samuelson, an economist at MIT and later also a Nobel laureate.
They had not been recruited for their nautical skills. In fact, apart from
Harris, the senator did not even know them.
The future president wanted to learn ‘the new economics’, which John
Maynard Keynes, an economist who we will learn more about in Section
14.6, had formulated in response to the Great Depression. When Kennedy
was a teenager in the decade before the Second World War, the US and
many other countries experienced a drastic fall in output (we can see this
for the US in Figure 14.1) and massive unemployment that persisted for
more than 10 years.
Heat pipe tunnel
587
Kennedy had a lot to learn. He admitted that he had barely passed the
only economics course he took at Harvard. He would later spend a day at
the America’s Cup sailing races being tutored by Harris, who assigned texts
for him to read. Harris later gave private lessons to the senator, shuttling by
air between Boston, where he worked, and Washington DC.
In 1948, Samuelson had written Economics, the first major textbook to
teach these new ideas. Harris promoted the same economic ideas in a book
that he edited in 1948 called Saving American Capitalism, a collection of 31
essays by 24 contributors. At that time, it seemed that capitalism needed
saving: the centrally planned economies of the Soviet Union and its allies, a
model promoted as the alternative to capitalism, had entirely avoided the
Great Depression. Kennedy needed economics to understand policies that
could promote economic growth, reduce unemployment, but also avoid
economic instability.
We have seen in Unit 13 that instability in the economy as a whole is
characteristic not only of economies dominated by agriculture, but also of
capitalist economies. Figure 14.1 shows the annual growth of real GDP in
the US economy since 1870.
A dramatic reduction in the severity of business cycles occurred after the
end of the Second World War. Figure 14.1 shows another important
development at that time: the increasing role of the government in the eco-
nomy. The red line shows the share of federal (national), local, and state
government tax revenue as a share of GDP. This is a good measure of the
size of the government relative to that of the economy.
The share of employment in agriculture, which we have seen was one
cause of volatility in the economy, fell from 50% in the 1870s to 20% by the
1918
End of WWI
1929
Start of Great
Depression
1933–36
President Roosevelt’s
New Deal
1945
End of WWII
1964
US war on
poverty begins
1965 US deploys
ground troops
in Vietnam
1970s
2008
Start of
global
financial
crisis
−20%
−10%
0%
10%
20%
30%
40%
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18
90
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95
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Year
G
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er
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ue
(a
s
a
pe
rc
en
to
f
G
N
P)
/
G
D
P
gr
ow
th
(%
)
GDP growth
Government size
Figure 14.1 Fluctuations in output and the size of government in the US
(1870–2019).
See more https://tinyco.re/1098434
The Maddison Project. 2020. 2020
Version (https://tinyco.re/8540274); US
Bureau of Economic Analysis. 2020. GDP
& Personal Income (https://tinyco.re/
3537217); FRED (https://tinyco.re/
38544076); Wallis, John Joseph. 2000.
‘American Government Finance in the
Long Run: 1790 to 1990’
(https://tinyco.re/5867884). Journal of
Economic Perspectives 14 (1) (February):
pp. 61–82.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
588
great moderation Period of low
volatility in aggregate output in
advanced economies between the
1980s and the 2008 financial crisis.
The name was suggested by James
Stock and Mark Watson, the eco-
nomists, and popularized by Ben
Bernanke, then chairman of the
Federal Reserve.
aggregate demand The total of the
components of spending in the eco-
nomy, added to get GDP: Y = C + I +
G + X – M. It is the total amount of
demand for (or expenditure on)
goods and services produced in the
economy. See also: consumption,
investment, government spending,
exports, imports.
beginning of the Second World War, yet there was no sign of the economy
becoming more stable over this period. As we have seen, households try to
smooth fluctuations in their consumption but they can’t always do this
successfully, partially because there are limits to how much they can
borrow.
The fact that the fluctuations in output growth dramatically reduced
while the size of government expanded does not mean that increased gov-
ernment spending stabilized the economy (remember: statistical
correlations do not mean causation). But there are good reasons to think
that the increase in the red line was part of the reason for the smoothing of
the black line. In this unit, we ask why the increased role of the government
in the economy is part of the explanation for the more stable economy in
the second half of the twentieth century.
What Harris taught Kennedy was influenced by the contrast between the
volatility of the economy before the Second World War, and the steadier
growth and absence of deep recessions afterwards. Why do economies
experience unemployment, inflation, and instability in output, and what
kinds of policies might address these problems?
In Unit 13, we took the household‘s viewpoint of the business cycle,
which allowed us to establish why fluctuations in employment and income
are costly, and how households try to limit the consequences for their
wellbeing. In this unit, we take the policymaker’s viewpoint. As we saw in
Figure 14.1, the big increase in the size of government after the Second
World War was accompanied by a reduction in the size of business cycle
fluctuations. After 1990, the business cycle in advanced economies became
even smoother, until the global financial crisis in 2008. This led to the
period from the early 1990s to the late 2000s being called the great
moderation.
14.1 THE TRANSMISSION OF SHOCKS: THE MULTIPLIER
PROCESS
In a capitalist economy, private investment spending is driven by
expectations about future post-tax profits. As we saw in Unit 13, spending
on investment projects tends to occur in clusters. Two reasons for this
observation are:
• Firms may adopt a new technology at the same time.
• Firms may have similar beliefs about expected future demand.
We need a tool to help us understand how decisions of firms (and house-
holds) to raise or reduce investment spending will affect the economy as a
whole. You will recall that some households are able to completely smooth
temporary bumps in their income, but that in credit-constrained house-
holds, higher income from getting a job or moving from part-time to full-
time work will also lead to higher consumption spending.
As a result, changes in current income influence spending, affecting the
income of others, so indirect effects through the economy amplify the
direct effect of a shock to aggregate demand (often shortened to AD)
created by an investment boom.
We will show how economists answer such questions as ‘how large
would the total direct and indirect impact of a rise in investment spending
be?’ or, ‘what would be the effect of lower government spending?’
14.1 THE TRANSMISSION OF SHOCKS: THE MULTIPLIER PROCESS
589
multiplier process A mechanism through which the direct and
indirect effect of a change in autonomous spending affects
aggregate output. See also: fiscal multiplier, multiplier model.
consumption function (aggregate) An equation that shows how
consumption spending in the economy as a whole depends on
other variables. For example, in the multiplier model, the other
variables are current disposable income and autonomous con-
sumption. See also: disposable income, autonomous
consumption.
consumption (C) Expenditure on
consumer goods including both
short-lived goods and services and
long-lived goods, which are called
consumer durables.
investment (I) Expenditure on
newly produced capital goods
(machinery and equipment) and
buildings, including new housing.
A statistic called the multiplier provides one way of answering this
question. Imagine there is a new technology. New spending takes place in
the economy as a result; output of the new capital goods rises, as do the
incomes of the people producing them. The circular flow of expenditure,
income, and output previously shown in Figure 13.6 illustrates this process.
• If the total increase in GDP is equal to the initial increase in spending: We say
that the multiplier is equal to 1.
• If the total increase in GDP is greater or less than the initial increase in spend-
ing: We say that the multiplier is greater than 1 or less than 1.
To see why GDP may rise by more than the initial
increase in investment spending, we explain what
economists call the multiplier process. We do
this by combining the very different behaviour of
consumption-smoothing and non-smoothing
households to represent consumption spending
for the economy as a whole. In this aggregate
consumption function, consumption depends
on current income, among other things. Recall
that in the model of Unit 13, consumption-
smoothing households will not increase their
consumption one-for-one, or even at all, in
response to a temporary €1 increase in their income. Credit-constrained
and other households who do not smooth, on the other hand, will increase
their current consumption by €1 in response to a temporary €1 increase in
their income.
In 2008, when governments considered temporary increases in govern-
ment spending and tax cuts in response to the recession that followed the
global financial crisis, the size of the multiplier became the subject of a
debate among policymakers and economists. We return to this debate later
in the unit.
As we shall see, the multiplier is greater than 1 if the additional
consumption spending resulting from a temporary €1 increase in income is
greater than zero but less than €1 (say, for example, 60 cents).
After explaining how this is a consequence of the multiplier process, we
will show that the validity of the assumptions we make in the multiplier
model depend on the state of the economy.
14.2 THE MULTIPLIER MODEL
We begin with a simple model that excludes the government and foreign
trade. In this model, there are two types of expenditure:
• consumption
• investment
We assume that aggregate consumption spending has two parts:
• A fixed amount: How much people will spend, independent of their
income. This fixed amount, also known as autonomous consumption,
is shown as c0 on the vertical axis of Figure 14.2.
• A variable amount: This depends on current income, and is an upward-
sloping red line in Figure 14.2.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
590
autonomous consumption Con-
sumption that is independent of
current income.
marginal propensity to consume
(MPC) The change in consumption
when disposable income changes
by one unit.
So we can write consumption spending in the form of an equation, which
we call the aggregate consumption function:
The term c1 gives the effect of one additional unit of income on consump-
tion, called the marginal propensity to consume (MPC). In Figure 14.2,
the slope of the consumption line is equal to the marginal propensity to
consume. A steeper consumption line means a larger consumption
response to a change in income. A flatter line means that households are
smoothing their consumption so that it does not vary much when their
incomes change. We assume that the marginal propensity to consume is
positive, but less than one. This means that only part of an increase in
income is consumed; the rest is saved.
We will work with an aggregate consumption function in which the
marginal propensity to consume, c1, equals 0.6. This means that an addi-
tional unit of income (Euros in this case) increases consumption by €1 × 0.6
= 60 cents.
Naturally, this average number hides large variation across households,
who differ in their wealth and in the credit constraints they face. Most
households have little wealth, and even in rich countries about one in four
households are credit-constrained. As we saw in Unit 13, weakness of will
also plays a role. So, both for households that are credit-constrained and for
those that do not save ahead of anticipated declines in income, consump-
tion closely tracks income.
Current income (output), Y
Consumption = c0+ c1Y
Slope of the consumption function = 0.6
= marginal propensity to consume = c1
0.6
1
Autonomous
consumption, c0Ag
gr
eg
at
e
co
ns
um
pt
io
n
sp
en
di
ng
, C
Figure 14.2 The aggregate consumption function.
1. Autonomous consumption
This is the fixed amount that house-
holds will spend that does not depend
on their current level of income.
2. Consumption that depends on
income
The upward-sloping line denotes the
part of consumption that depends on
current income (and hence on current
output).
3. The marginal propensity to consume
The slope of the consumption line is
equal to the marginal propensity to
consume.
14.2 THE MULTIPLIER MODEL
591
Households with low wealth smooth consumption very little if their
income falls sharply. The marginal propensity to consume for this group is
closer to 0.8. For the small fraction of households who hold the majority of
wealth, however, current income plays a very small role in determining
consumption, and their marginal propensity to consume is closer to zero.
This means that for rich households, an increase in current income of €1
would raise their consumption by just a few cents.
The term c0 in the aggregate consumption function captures all the
other influences on consumption that are not related to current income.
Taken literally, it is how much a person with no income would consume,
but this is not the best way to think about it. It is just the consumption that
is independent of income, and for this reason we call it autonomous con-
sumption.
Since the consumption function only explicitly includes current income,
expectations about future income will be included in autonomous con-
sumption. To see what this means in practice, recall from Unit 13 that
consumption will change as a result of people becoming more or less
optimistic about their future employment and earnings prospects.
Figure 14.3 illustrates how expectations affected consumption in the fin-
ancial crisis of 2008 and highlights the exceptional nature of this episode.
The figure shows how consumer confidence changed in the US over the
course of the crisis. The consumer sentiment index that we have used is the
University of Michigan Surveys of Consumers (https://tinyco.re/7469765).
It is based on monthly interviews with 500 households, and asks how they
view prospects for their own financial situation and for the general econ-
omy over the short and long term. The figure also plots the evolution of a
number of key macroeconomic indicators: disposable income, consumption
of durable goods like cars and home furnishings, and consumption of non-
durable goods, such as food. All of the series in Figure 14.3 are shown as
index numbers, with the first quarter of 2008 as the base year.
We notice:
• Consumption of non-durable goods went down slightly more than disposable
income: It fell by 3% during the period. Contrary to the predictions of
75
80
85
90
95
100
105
110
2008 Q1 2008 Q3 2009 Q1 2009 Q3
In
de
x
(2
00
8
Q
1
=
10
0)
Real disposable income
Real consumption of non-durable
goods
Consumer sentiment index
Real consumption of durable
goods
Figure 14.3 Fear and household consumption in the US during the global financial
crisis (2008 Q1–2009 Q4).
Federal Reserve Bank of St. Louis. 2015.
FRED (https://tinyco.re/5104028).
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
592
goods market equilibrium The
point at which output equals the
aggregate demand for goods
produced in the home economy.
The economy will continue produc-
ing at this output level unless
something changes spending
behaviour. See also: aggregate
demand.
capacity utilization rate A measure
of the extent to which a firm,
industry, or entire economy is
producing as much as the stock of
its capital goods and current
knowledge would allow.
consumption smoothing, households were sufficiently worried about
their future prospects that they made adjustments to their spending on
non-durables.
• Consumption of durables decreased much more dramatically than disposable
income: It decreased by 10% in the first year.
Why the sudden drop in consumption of consumer durables? An important
reason is that households were suddenly fearful about the future of their
jobs, as shown by the sharp decline in the consumer sentiment index in
Figure 14.3. The collapse of the investment bank Lehman Brothers in
September 2008 (https://tinyco.re/3073658), worries about the stability of
the banking system, and a higher burden of household debt due to falling
house prices led households with mortgages to postpone purchases of
expensive items like cars and fridges. It’s important to remember that
spending on consumer durables can easily be postponed. In this sense it is
more like an investment than a consumption decision (even though con-
sumer durables are counted as part of consumption in the national
accounts). As a result, we would expect the series for consumer durables to
be more volatile than for non-durable consumption.
We now show how a shock is transmitted through the economy. In
Figure 14.4 we show the amount of output produced by the economy (on
the horizontal axis) and the demand for output (on the vertical axis).
Everything is measured in real terms because we are interested in how
changes in aggregate demand create changes in output and employment.
The 45-degree line from the origin of the diagram shows all the combin-
ations in which output is equal to aggregate demand. This corresponds to
the circular flow discussed in Unit 13, where we saw that spending on
goods and services in the economy (aggregate demand) is equal to produc-
tion of goods and services in the economy (aggregate output). You can see
this because with a 45-degree line the horizontal distance (output) is equal
to the vertical distance (aggregate demand). We can therefore say that:
But how do we know where the economy is on the 45-degree line? Is it at a
position of low output, which would mean high unemployment, or is it at a
position of high output, which would mean low unemployment?
We determine this position by analysing the individual components of
aggregate demand. We assume that firms are willing to supply any amount
of the goods demanded by those making purchases in the economy; they
are not operating at full capacity utilization. Because we have assumed
that there is no government spending or trade with other economies, in this
model there are just two components of aggregate spending:
• Consumption: We take the consumption line introduced in Figure 14.2.
Because the marginal propensity to consume is less than one, the con-
sumption line is flatter than the 45-degree line, which has a slope of one.
• Investment: We assume investment does not depend on the level of
output.
14.2 THE MULTIPLIER MODEL
593
The equation for aggregate demand is therefore:
So adding investment to the consumption line simply leads to a parallel
upward shift. In this respect, investment is similar to autonomous con-
sumption. We can see from Figure 14.4 that the aggregate demand line has
an intercept of c0 + I, a slope of c1, and is flatter than the 45-degree line.
In Figure 14.4 we now have a picture showing how the level of output in
the economy is determined. Output is equal to aggregate demand (the
45-degree line), and aggregate demand is equal to c0 + c1Y + I (the flatter
line), so the economy must be at point A where the two lines cross.
The same figure tells us the effect of a change in autonomous consump-
tion (c0) or investment. We study this change exactly as we did the changes
in supply and demand in Unit 11: we see how the change makes the old
outcome no longer an equilibrium, and then we locate the new equilibrium.
The expected change is the movement from the old to the new equilibrium.
Changes in autonomous consumption or investment displace the old
equilibrium because they change aggregate demand, which in turn alters
Autonomous
consumption
and investment
c0 + I
Autonomous
consumption, c0
Ag
gr
eg
at
e
de
m
an
d,
A
D
Aggregate demand =
c0+ c1Y+ I
C= c0+ c1Y
A
On 45-degree line:
output = aggregate demand
45º
Output (income), Y
Figure 14.4 Goods market equilibrium: The multiplier diagram.
1. Goods market equilibrium
Point A is called a goods market equi-
librium: the economy will continue
producing at that output level unless
something changes spending
behaviour.
2. The 45-degree line
The 45-degree line from the origin of
the diagram shows all the combina-
tions in which output is equal to
aggregate demand, meaning the eco-
nomy is in goods market equilibrium.
3. Consumption
The first component of aggregate
demand is consumption, which is
represented by the consumption line
introduced in Figure 14.2.
4. Investment
Adding investment to the consumption
line simply leads to a parallel upward
shift of the aggregate demand line.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
594
the level of output and employment. In Figure 14.5, we take the multiplier
diagram and reduce investment. We choose a reduction in investment of
€1.5 billion. Follow the steps in Figure 14.5 to see what happens.
We trace the effect of the fall in investment through the economy in
Figure 14.5. The first-round effect is that the fall in investment cuts aggreg-
ate demand by €1.5 billion. But lower spending also means lower
production and lower incomes, and firms will fire workers as a result,
leading to a further decline in spending. Think of credit-constrained house-
holds where some members lose their job: they would like to keep
consumption stable, but when their income falls they are unable to borrow
enough to sustain that level of consumption, so they reduce their spending,
which leads to further cuts in production and incomes. The consumption
equation tells us that this kind of behaviour leads to a fall in aggregate con-
Output (income), Y
c0 + I
c0 + I′
Ag
gr
eg
at
e
de
m
an
d,
A
D
AD1= c0+ c1Y+ I
After multiplier process, output has fallen
by €3.75 bn; multiplier is 3.75/1.5 = 2.5
Z
Y = AD on 45-degree line
45º
E
C
D
B
A
1.5
3.75
1.5
1.5
Decrease in investment of €1.5 bn;
investment falls from I to I′
AD2= c0+ c1Y+ I′
Figure 14.5 The multiplier in action: An investment-led recession.
1. Goods market equilibrium
The economy starts at point A, in goods
market equilibrium.
2. A fall in investment
The fall in investment cuts aggregate
demand by €1.5 billion, and the eco-
nomy moves vertically downward from
point A to point B.
3. Firms cut back
With demand lower, firms cut back pro-
duction and reduce employment. With
output and employment lower,
incomes fall by €1.5 billion. This is the
move from B to C.
4. A fall in consumption
Once households’ incomes fall, they
reduce their consumption, because
they may be credit-constrained. The
consumption equation tells us that this
kind of behaviour initially leads to a
fall in aggregate consumption of 0.6
times the fall in income. This is the
distance from point C to point D.
5. Firms cut back again
Firms respond by cutting production,
output falls, and the economy moves
from point D to point E.
6. … and so on
The process will go on until the eco-
nomy reaches point Z.
7. The new aggregate demand line
This goes through point Z and shows
the new goods market equilibrium of
the economy following the investment
shock.
8. The fall in output as a result of the
shock
The total fall in output exceeds the
initial size of the decline in investment;
output has fallen by €3.75 billion.
9. The multiplier is equal to 2.5
The total change in output is 2.5 times
larger than the initial change in invest-
ment.
14.2 THE MULTIPLIER MODEL
595
multiplier model A model of
aggregate demand that includes
the multiplier process. See also:
fiscal multiplier, multiplier process.
sumption of 0.6 times the fall in income. The process will go on until the
economy reaches point Z.
Following the investment shock, the intercept of the line has moved
down by €1.5 billion, causing a parallel shift in the aggregate demand line.
Output has fallen by €3.75 billion, more than the fall in investment of €1.5
billion: this is the multiplier process.
In this case, the multiplier is equal to 2.5, because the total change in
output is 2.5 times larger than the initial change in investment. A multiplier
of 2.5 is unrealistically large. As we shall see in the next section, once taxes
and imports are introduced in the model, the multiplier shrinks.
We call the model of aggregate demand that includes the multiplier
process the multiplier model. This is a summary:
• A fall in demand leads to a fall in production and an equivalent fall in income:
This leads to a further (smaller) fall in demand, which leads to a further
fall in production, and so on.
• The multiplier is the sum of all these successive decreases in production:
Eventually, output has fallen by a larger amount than the initial shift in
demand. Output is a multiple of the initial shift.
• Production adjusts to demand: Firms supply the amount of goods
demanded at the prevailing price. When demand falls, firms adjust pro-
duction down. The model assumes that they do not adjust their prices.
Note that the economy we are studying is one in which we assume there are
underutilized resources in the form of spare capacity in production
facilities and underemployed labour. We also assume that wages are not
affected by changes in the level of output. For the multiplier process to
work in the same way in response to a rise in investment, the assumption of
spare capacity and fixed wages means that costs will not rise when output
goes up, so firms will be happy to supply the extra output demanded
without adjusting their prices. Otherwise some of the increased spending
will translate into higher prices or wages rather than higher real output—as
we discuss in the next unit.
If the economy is not characterized by spare capacity and constant
wages, the multiplier will be smaller than what we find here.
We can also show the effect on output by combining the two equations
that determine the lines in the multiplier diagram. The 45-degree line is
simply the equation Y = AD. Combining this with the equation for AD
gives us:
Collecting terms on the left hand side,
We then divide through by (1 − c1):
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
596
autonomous demand Components
of aggregate demand that are
independent of current income.
We can now calculate how much output will increase or decrease using the
value of the multiplier times the change in autonomous demand.
Discover another way to summarize our findings from the diagram
algebraically in the Einstein at the end of this section.
The change in output in Figure 14.5 is 2.5 times greater than the initial
shock to investment, which means that the shock has been amplified. In
algebra, we write this as ΔY = kΔI, and say it as ‘delta Y (the change in
output) is equal to k, the multiplier, times delta I (the change in investment)’.
QUESTION 14.1 CHOOSE THE CORRECT ANSWER(S)
Figure 14.2 (page 591) depicts a consumption func-
tion 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?
The marginal propensity to consume (MPC) is the
proportion of current income spent on consump-
tion, C/Y.
The MPC is given by the line’s intercept on the ver-
tical axis.
The MPC is normally less than 1 as some house-
holds are able to smooth their consumption.
If the current income of a country is Y = $100
trillion and the MPC = 0.6, then the aggregate con-
sumption spending is C = $60 trillion.
QUESTION 14.2 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts the change in the aggregate goods
market equilibrium when there is a €2 billion increase in investment.
Output (income), Y
c0 + I
c0 + I′
Ag
gr
eg
at
e
de
m
an
d,
A
D
AD = c0+ c1Y+ I
Increase in investment of €2 bn;
investment rises from I to I′
AD = c0+ c1Y+ I′
A
Y = AD on 45-degree line
45º
B
C
D
Z
2
4 bn
2 bn
E
2 bn
The economy’s marginal propensity to consume is 0.5. Based on this
information, which of the following statements is correct?
The new goods market equilibrium after the investment increase is E.
Aggregate demand increases by a total of €2 billion × 0.5 = €1
billion due to the increase in investment.
The multiplier is 2.
The distance between C and D is three-quarters the distance
between A and B (€1.5 billion).
14.2 THE MULTIPLIER MODEL
597
EINSTEIN
Calculating the multiplier
We consider the effect of an increase in investment of €1.5 billion. We
can summarize our findings from the multiplier diagram by doing some
algebra. To get the multiplier, we can calculate the total increase in pro-
duction after n + 1 rounds of the process. Each round of the process
matches the circular flow diagram. The first-round increase in demand
and production is €1.5 billion. The second-round increase in demand
and production is (c1 × €1.5 billion), the third-round increase in demand
and production is c1 × (c1 × €1.5 billion) = (c12 × €1.5 billion), and so on.
Following this logic, the total increase in demand and production
after n + 1 rounds is the total sum of these changes:
Because the marginal propensity to consume is lower than one, we can
show that the total sum in the brackets reaches a limit of 1/(1 − c1) as n
gets large. This is because the term in the brackets is, mathematically, a
geometric series. We show this as follows.
If k is the multiplier, we have:
Now multiply both sides by (1 – c1) to get:
Now divide again by (1 − c1):
As n gets large, assuming c1 < 1, the numerator tends to 1. So, in the
limit:
In the example, the marginal propensity to consume is, on average, 0.6.
This implies that the multiplier is equal to:
We can then apply the multiplier to the initial change in investment of
€1.5 billion to find the sum of all the successive increases in production
triggered by the initial hike in investment and aggregate demand:
2.5 × €1.5 billion = €3.75 billion.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
598
mortgage (or mortgage loan) A
loan contracted by households and
businesses to purchase a property
without paying the total value at
one time. Over a period of many
years, the borrower repays the
loan, plus interest. The debt is
secured by the property itself,
referred to as collateral. See also:
collateral.
precautionary saving An increase
in saving to restore wealth to its
target level. See also: target
wealth.
target wealth The level of wealth
that a household aims to hold,
based on its economic goals (or
preferences) and expectations. We
assume that households try to
maintain this level of wealth in the
face of changes in their economic
situation, as long as it is possible to
do so.
Great Depression The period of a
sharp fall in output and employ-
ment in many countries in the
1930s.
••14.3 HOUSEHOLD TARGET WEALTH, COLLATERAL, AND
CONSUMPTION SPENDING
From Unit 13, we know that consumption is the largest component of GDP
in most economies. Therefore an important part of understanding changes
in output and employment is understanding why consumption changes.
We saw that a shock to investment shifts the aggregate demand curve,
and is transmitted through the economy as households adjust their spend-
ing in response to changes in income. We focused on incomplete consump-
tion smoothing, such as credit constraints. This behaviour is reflected in the
size of the multiplier and the slope of the aggregate demand curve. But con-
sumption and saving behaviour can also shift the aggregate demand curve.
A shift in aggregate demand can be caused by a shift in autonomous con-
sumption, represented by the term c0 in the aggregate consumption
function, C = c0 + c1Y. A change in c0 will in turn produce a multiplier
response of output and employment through the circular flow of
expenditure, output, and income in the same way as the fall in investment
in the previous section was multiplied.
Think about a family with a mortgage on its house. If the price of
houses falls, the family will be concerned that its wealth, too, has fallen. A
likely reaction to this is for the household to save more. This is called
precautionary saving. One way to analyse this behaviour is to assume that
households have in mind a target wealth that they aim to hold.
When something happens to affect the stock of the household’s wealth
relative to this target, it reacts by either increasing or decreasing its savings
to restore wealth back to its target level. If this adjustment involves
precautionary saving, it is modelled as a fall in autonomous consumption.
In 1929, a downturn in the US business cycle that initially appeared
similar to others in the preceding decade turned into a large-scale eco-
nomic disaster—the Great Depression.
The fall in output and employment during the Great Depression
highlights two ways in which aggregate consumption might fall—credit
constraints in the multiplier process, and changes in wealth relative to
target wealth.
To understand the economic mechanisms at work in the Great Depres-
sion, we use the multiplier diagram shown in Figure 14.6. Point A shows
the initial situation of the economy in the third quarter of 1929. There was
then a fall in investment. This shifts the aggregate demand curve from the
pre-crisis to the crisis level. The dotted line from point B shows the level of
output that would have been observed in the business cycle trough if the
usual multiplier process had been at work. There would have been a
recession, but no Great Depression. But the downturn was made much
worse because there was a fall in the demand for consumer goods, even by
those who kept their jobs.
Consumption was cut back through two mechanisms:
• The shift from A to B: As output and employment fell, some households
cut spending on housing and consumer durables because they were
credit-constrained, and therefore unable to borrow in the deteriorating
conditions. Some economists have estimated that the size of the multi-
plier at the time was about 1.8.
• The shift from B to C: Even households that remained in work cut back
spending because it became increasingly clear that the downturn was the
Christina D. Romer. 1993. ‘The
Nation in Depression’
(https://tinyco.re/4965855). Journal
of Economic Perspectives 7 (2)
(May): pp. 19–39.
14.3 HOUSEHOLD TARGET WEALTH, COLLATERAL, AND CONSUMPTION SPENDING
599
new reality, not a temporary shock. This shifted the consumption func-
tion down and pulled the economy further into depression from B to C
in Figure 14.6.
Research done since the Great Depression (which we examine in more
depth in Unit 17) provides a number of explanations for the fall in
autonomous consumption in the US:
• Uncertainty: Uncertainty about the state of the economy provoked by the
dramatic stock market crash of October 1929 made both firms and
households more cautious, prompting them to postpone purchases of
machinery and equipment and consumer durables.
• Pessimism and the desire to save more: Households also became more
pessimistic about their ability to maintain current levels of spending, as
they feared unemployment and lower earnings in the future. Their
assessment of their material wealth was also affected as the prices of
houses and financial assets fell. The 1920s had seen a build-up of debt by
households, as they were able to use instalment agreements for the first
time to buy consumer durables.
• The banking crisis and the collapse of credit: A third factor that shifted the
aggregate demand line down to the level labelled ‘trough’ was the
banking crisis of 1930 and 1931, which affected both consumption and
Subsequent fall in aggregate demand due to shift
downward in the consumption function and
investment function
206 bn
1933 Q1
(trough)
324 bn
1929 Q3
(peak)
Ag
gr
eg
at
e
de
m
an
d,
A
D
(c
on
st
an
t 1
97
2
$) On 45-degree line:
output = aggregate demand
AD (pre-crisis)
AD (crisis)
AD (trough)
45º
A
B
C
Initial fall in aggregate demand due to fall in
investment late 1929/early 1930
Output, Y (constant 1972 $)
Figure 14.6 Aggregate demand in the Great Depression
Robert J. Gordon. 1986. The American
Business Cycle: Continuity and Change
(https://tinyco.re/5375612). Chicago, Il:
University of Chicago Press.
1. The 1929 peak
Point A shows the initial situation of the
economy.
2. A fall in investment
This shifts the aggregate demand curve
from the pre-crisis to the crisis level.
3. A normal recession
The economy would normally be at
point B.
4. The 1933 trough
However, instead of a typical
downswing (from A to B), output fell by
much more than can be explained by
the multiplier process alone, which is
shown by the move from B to C.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
600
human capital The stock of
knowledge, skills, behavioural
attributes, and personal
characteristics that determine the
labour productivity or labour earn-
ings of an individual. Investment in
this through education, training,
and socialization can increase the
stock, and such investment is one
of the sources of economic growth.
Part of an individual’s endowments.
See also: endowment.
equity An individual’s own invest-
ment in a project. This is recorded
in an individual’s or firm’s balance
sheet as net worth. See also: net
worth. An entirely different use of
the term is synonymous with
fairness.
financial accelerator The
mechanism through which firms’
and households’ ability to borrow
increases when the value of the
collateral they have pledged to the
lender (often a bank) goes up.
investment. There was a wave of failures of small, weak, and largely
unregulated banks across the US. The system of small banks was
vulnerable to panic. Savers began to fear that they would not be able to
get access to their deposits. As explained in Unit 10, as panic spread
from bank to bank, bank runs affected the entire banking system. With
the collapse of the banking system, households lost deposits and small
firms lost their access to credit.
To illustrate why households who were not affected by credit constraints
nevertheless cut consumption, we look at the composition of a household’s
wealth or assets. In Unit 10 we introduced the concept of wealth by
comparing it with the volume of water in a bathtub. At that time we focused
on material wealth. In Figure 14.7 we extend the concept of wealth to broad
wealth so as to include the household’s expected future earnings from
employment, known as the value of its human capital.
Follow the analysis in Figure 14.7 to see the composition of the house-
hold’s broad wealth, which is equal to the value of all its assets, minus its
debt (which we assume is a mortgage on the house).
As we shall see:
• If target wealth is above expected wealth: The household will increase
savings and decrease consumption.
• If target wealth is below expected wealth: The household will decrease
savings and increase consumption.
In early 1929, how would a household with the wealth position shown in
column A of Figure 14.8 have interpreted news about factory closures, the
collapse of the stock market, and bank failures? How would it have adjusted
spending on consumer durables, housing, and non-durables? Answers to
these questions help tell us why the Great Depression happened.
• Before the Depression: Viewed from early in 1929 (column A in Figure
14.8), households are shown as making consumption decisions in line
with their expectations: total wealth is equal to target wealth.
• The Depression: By late 1929 (column B), the downturn was underway
and beliefs had changed. With job losses throughout the economy,
households revised expected earnings downward. Falling asset prices (of
shares and houses) reduced the value of the household’s material wealth.
The result was a gap between the household’s target wealth and expected
wealth. This helps to explain the cutback in consumption by households
who could (and in an ordinary downturn, would) have helped to smooth
a temporary fall in aggregate demand. Instead, these households
increased their saving. This fall in autonomous consumption is part of
the explanation for the downward shift of the aggregate demand curve
from crisis to trough in Figure 14.6.
• The financial accelerator, collateral, and credit constraints: Changes in
household wealth affect consumption through another channel. In Unit
10, we saw that having collateral may enable a household to borrow. An
important example is the case of home loans, where the bank extends a
loan using the value of the house as collateral. If the value of your house
falls, the bank will be willing to lend less, making you more credit-
constrained, which may reduce your consumption.
14.3 HOUSEHOLD TARGET WEALTH, COLLATERAL, AND CONSUMPTION SPENDING
601
The same mechanisms are at work if house prices increase, which will tend
to increase consumption:
• For those who are not credit-constrained: If the value of your house
increases, this improves your net worth and raises your wealth relative
to target. We would predict that this would reduce your precautionary
savings, increasing consumption.
• For those who are credit-constrained: A rise in the price of your house can
lead you to increase your consumption spending because the higher
collateral enables you to borrow more.
324 bn
1929 Q3
(peak)
Debt
Home equity
Financial wealth
Expected
future earnings
from employment
Net worth
Total broad wealth
including expected
future earnings
from employment
Target broad wealth
Home equity =
value of house – debt
Value of house
Figure 14.7 Household wealth: Key concepts.
1. Expected future earnings from
employment
These are represented by the orange
rectangle.
2. Financial wealth
This is the green rectangle.
3. The household’s ownership stake in
the house
This is the blue rectangle.
4. The household’s total broad wealth
This is the sum of the green, blue, and
orange rectangles.
5. Households also hold debt
This is shown by the red rectangle.
6. The household’s net worth
Also called material wealth. We find it
by taking the total assets (excluding
expected future earnings), which is the
value of the house plus financial
wealth, and then subtracting the debt it
owes.
7. The value of the house
This is equal to the household’s equity
in the house, plus what it owes to the
bank (the mortgage).
8. Target wealth
For the household shown in the figure,
expected broad wealth (orange + green
+ blue) is equal to target wealth.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
602
EXERCISE 14.1 A HOUSEHOLD’S BALANCE SHEET
Consider a family of two parents and two children who have a mortgage
on their home. They have paid off half the mortgage. The family also owns
a car and a portfolio of shares in companies. They spend their income on
food, clothing, and private school fees, and have retirement savings held in
a pension fund.
1. Which of these items would be on a balance sheet for the household?
2. Using the example of the bank’s balance sheet in Figure 10.16 as a
guide, construct an annual balance sheet for your hypothetical house-
hold. You may want to research the typical values for these items for a
family of this type.
324 bn
1929 Q3
(peak)
Debt
Debt
Home equity
Home equity
Financial wealth
Financial wealth
Expected
future earnings
from employment Expected
future earnings
from employment
Total
broad
wealth
Increase in savings
to restore target
wealth
Early 1929
A
Target broad wealth
B
Late 1929–31
Figure 14.8 The Great Depression: Households cut consumption to restore their
target broad wealth.
1. Before the Depression
Households are making consumption
decisions in line with their expectations
about their net worth and future earn-
ings from employment. This is shown by
the fact that total wealth is equal to
target wealth.
2. The Depression
In late 1929, column B, the downturn
was underway and beliefs had
changed.
3. Precautionary saving
The result was a gap between the
household’s target wealth and expec-
ted wealth. Households increased their
savings.
14.3 HOUSEHOLD TARGET WEALTH, COLLATERAL, AND CONSUMPTION SPENDING
603
EXERCISE 14.2 HOUSING IN FRANCE AND GERMANY
In France and Germany, it is difficult for a household to increase its
borrowing based on an increase in the market value of the house. In
addition, large down-payments (as a percentage of the house price) are
required for house purchases.
1. On the basis of this information, how would you expect a rise in house
prices in France or Germany to affect spending by households?
2. In the US or UK, loans are more easily available based on a rise in
home equity and only a small down-payment is required. How would
you expect your answer to question 1 to change when considering the
US or UK?
3. What do you conclude about the role of the financial accelerator in
France and Germany compared with the UK and the US?
Note: A December 2014 VoxEU article, ‘Combatting Eurozone deflation: QE
for the people’ (https://tinyco.re/4854300), tells you more about the
influence of a change in house prices on spending in Europe and the US.
QUESTION 14.3 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct regarding household
wealth?
A household’s material wealth is its financial wealth plus the value
of its house.
The total broad wealth equals material wealth plus expected future
earnings.
A household adjusts its precautionary saving in response to changes
in its target wealth.
If the household’s target wealth is above its expected wealth, then
it will decrease savings and increase consumption.
••14.4 INVESTMENT SPENDING
In Unit 13, we contrasted the volatility of investment with the smoothness
of consumption spending. But how do firms make investment decisions?
Think of the manager or owner of a firm deciding what to do with their
accumulated profits. There are four choices:
1. Dividends: Allocate the funds to managerial or employee salaries, or to
dividends for owners.
2. Saving: Buy an interest-bearing financial asset such as a bond, or retire
(pay off) existing debt.
3. Investment abroad: Build new productive capacity in another country.
4. Investment at home: Build new capacity in the home country.
The fourth choice is called investment in our model (the third choice is also
investment, but since it is spent in the foreign country it is measured in the
foreign country’s national accounts as part of its I, not in the home
country’s).
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
604
monetary policy Central bank (or
government) actions aimed at
influencing economic activity
through changing interest rates or
the prices of financial assets. See
also: quantitative easing.
If we assume that there is no reason to change salaries then we can also
break down the owner’s decision as we did Marco’s decision in Unit 10:
• The owner has the choice to consume now or consume later: Taking the
revenue as dividends means the owner can, if desired, simply consume
the extra income now.
• If the decision is to consume later: The owner can either save (lend by
buying a financial asset such as a bond or retire debt) or invest in a new
project.
• If the decision is to invest: Whether the owner does it in the home country
or abroad will depend on the expected rate of profit for the potential
investment projects in the two locations.
The desirability of consuming more now rather than later depends on the
owner’s discount rate (ρ), as discussed in Unit 10. The owner will compare
this to the return they can get by not consuming now. If the firm saves by
buying a financial asset then the return is the interest rate r. If the firm
invests in productive capacity then the return will be the profit rate on
investment, which we will call Π as in Unit 10:
• If ρ is greater than both r and Π: The owner will keep the funds and
increase consumption spending.
• If r is greater than ρ and Π: The decision will be to repay debt or purchase
a financial asset.
• If Π is greater than ρ and r: The owner will invest (either at home or
abroad).
Because of these options, the interest rate is one of the factors determining
whether investment takes place. We saw in Unit 10 that this can be altered
by central bank policy (monetary policy). The interest rate is the oppor-
tunity cost of purchases of machinery, equipment, and structures that
increase the capital stock—if you have money available, you could save it
with a return of r instead of investing it. Alternatively, if you do not have
money available, then the cost of borrowing for investment is also r. If we
rank investment projects by their expected post-tax rate of profit, then a
lower interest rate raises the number of projects for which the expected rate
of profit is greater than the interest rate. We saw this when Marco faced the
decision of whether or not to invest (Figure 10.10). Thus a higher interest
rate reduces investment, and a lower interest rate increases it.
Figure 14.9 illustrates this fact for an economy consisting of two firms,
A and B. For each firm in this example, there are three investment projects
of different scale and rate of return. They are shown in decreasing order of
the expected rate of profit. Follow the analysis in Figure 14.9 to see how the
interest rate determines which investment projects go ahead. The lower
panel aggregates the two firms to show how investment in the economy as a
whole responds to a change in the interest rate.
In Figures 14.10a–c, we look at how a change in profit expectations
affects investment.
In the two-firm economy in Figure 14.10a, the expected rate of profit
for each project rises because of an improvement in the supply-side condi-
tions in the economy. The height of each column rises, and as a result, there
is more investment at a given interest rate.
14.4 INVESTMENT SPENDING
605
expropriation risk The probability
that an asset will be taken from its
owner by the government or some
other actor.
An upward shift can be caused by a fall in expected input prices, such as
a forecast fall in the price of energy or wages, or a fall in taxation over the
life of the project.
Another example of a positive supply effect is an improvement in the
security of property rights so that there is a smaller chance that the govern-
ment or another powerful actor (such as a landowner, like Bruno in Unit 5,
who might threaten a smallholder) will take over ownership of the invest-
ment project. This is called a fall in the risk of expropriation and is an
example of an improvement in the business environment.
Expected profit rate
(project 1)
Project 2 Project 3
Increase in investment
Expected profit rate
(project 1)
Fall in interest rate
Project 2 Project 3Project 1
Total investment, aggregate economy
Investment, Firm A (left) and Firm B (right)
1
2
3
4
5
1
2
3
4
5
In
te
re
st
ra
te
, p
ro
fit
ra
te
(%
)
In
te
re
st
ra
te
, p
ro
fit
ra
te
(%
)
1
2
3
4
5
Project 1
Figure 14.9 Investment, expected rate of profit, and the interest rate in an economy
with two firms.
1. Firm A
Firm A has three investment projects of
different scale and rate of profit. They
are shown in decreasing order of the
expected rate of profit.
2. Firm B
Firm B also has three different invest-
ment projects.
3. The decision to invest
If the interest rate remains at 5%, Firm
A goes ahead with project 1 and Firm B
does not invest at all. But if the interest
rate was 2%, A would undertake
projects 1 and 2 and B would
undertake all three of its projects.
4. The decision to invest
The lower panel aggregates the
potential investments of the two firms,
arranged by the expected profit rate as
before.
5. Aggregate investment increases
Investment in the economy increases
after a fall in the interest rate. Five
projects go ahead, instead of just one.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
606
In Figure 14.10b, the height of the columns remains unchanged, but
their width (representing the amount of investment that is profitable in
many projects) has increased. This is the result of a permanent increase in
demand and the lack of sufficient capacity to meet forecast sales.
1
2
3
4
5
In
te
re
st
ra
te
, p
ro
fit
ra
te
(%
)
Investment
Figure 14.10a The aggregate economy, where the expected rate of profit rises for a
given set of projects (supply effect).
Investment
In
te
re
st
ra
te
, p
ro
fit
ra
te
(%
)
1
2
3
4
5
Figure 14.10b The aggregate economy, where the desired capacity rises for each
project (demand effect).
1. Interest rate at 5%
With the interest rate equal to 5%, only
one project will go ahead.
2. Improvement in supply conditions
The improvement in supply conditions
increases the expected rate of profit for
each project.
3. Effect on investment
For the same interest rate, investment
rises: two more projects go ahead.
1. Interest rate at 2%
With the interest rate equal to 2%, and
the initial desired capacity, investment
is shown by the darker coloured blocks.
2. Higher forecast demand
Pressure on existing capacity from
higher forecast demand raises the
desired size of each project, so invest-
ment rises to include the lighter
coloured blocks.
14.4 INVESTMENT SPENDING
607
investment function (aggregate) An equation that shows how
investment spending in the economy as a whole depends on
other variables, namely, the interest rate and profit
expectations. See also: interest rate, profit.
In an economy with many thousands of firms,
a downward-sloping line (as in Figure 14.10c)
represents the potential investment projects. This
is called the aggregate investment function. The
response of investment to a change in the interest
rate is shown as a shift from C to E. Figure 14.10c
also shows the effect of a change in the
profitability of investment, which arises from supply and demand effects
and raises investment from C to D for the same interest rate.
The empirical evidence suggests that business spending on machinery
and equipment is not very sensitive to the interest rate. The limited effect of
changes in the interest rate on business investment (illustrated by the
steepness of the lines in the figure) highlights the importance of the supply-
and demand-side factors that shift the investment function (Figures 14.10a
and 14.10b).
The interest rate affects investment spending outside the business sector
through its effects on households’ decisions to purchase new or larger
homes, which influence new housing construction. The interest rate also
has substantial effects on the demand for durable consumer goods, such as
cars and home appliances, which are often purchased using credit.
3
4
Investment (I),
holding profit
expectations constant
Investment (I),
higher profit
expectations
E
C D
Investment
In
te
re
st
ra
te
, p
ro
fit
ra
te
(%
)
Figure 14.10c Aggregate investment function: Effects of the interest rate and profit
expectations.
1. Potential investment projects
In an economy with many thousands of
firms, all their potential investment
projects are represented by a down-
ward-sloping aggregate investment
function.
2. Investment increases
In response to a fall in the interest rate,
investment increases from C to E.
3. An increase in profit expectations
This shifts the investment function to
the right: if the interest rate is held con-
stant at 4%, investment increases from
C to D.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
608
QUESTION 14.4 CHOOSE THE CORRECT ANSWER(S)
Figure 14.9 (page 606) depicts possible investment projects for Firms A
and B.
Based on this information, which of the following statements is
correct?
Both firms only undertake their project 1 when the interest rate is
5%.
The central bank can ensure that all projects will be undertaken by
cutting the interest rate to 1.5%.
When the demand is expected to permanently increase beyond the
capacity of existing plants and equipment, the level of investment
increases due to an upward shift in the expected profit rate.
An expected rise in energy prices leads to a fall in the expected
profit rates, resulting in fewer projects being profitable at a given
interest rate. This results in reduced investment.
QUESTION 14.5 CHOOSE THE CORRECT ANSWER(S)
Figure 14.10c (page 608) depicts the aggregate investment function of
an economy.
Based on this information, which of the following statements is
correct?
Ceteris paribus, an increase in the interest rate would lead to a fall
in investment due to an inward shift of the investment line.
A rise in corporate tax would shift the investment line outwards.
A forecast of a permanent demand increase shifts the investment
line outwards.
A steeper line indicates the higher sensitivity of the level of aggreg-
ate investment to changes in interest rate.
14.4 INVESTMENT SPENDING
609
•14.5 THE MULTIPLIER MODEL: INCLUDING THE
GOVERNMENT AND NET EXPORTS
Here we add governments and central banks to the model so that we can
show how they can stabilize (or destabilize) the economy after a shock. As
before, we assume that firms are willing to supply any amount of goods
demanded, so:
We saw in Unit 13 that when we include the government and interactions
with the rest of the world through exports and imports, aggregate demand
can be split into these components:
To understand the aggregate demand function as shown above, it is useful
to go through each component in turn:
Consumption
Household consumption spending depends on post-tax income. The gov-
ernment charges a tax t, which we assume is proportional to income. The
income left after the payment of tax, (1 − t)Y, is called disposable income.
The marginal propensity to consume, c1, is the fraction of disposable
income (not pre-tax income) consumed. This means that in the aggregate
consumption function:
• Spending on consumption is written as: C = c0 + c1(1 − t)Y.
• All of the influences on consumption apart from current disposable
income are included in autonomous consumption, c0, and will therefore
shift the consumption function in the multiplier diagram. These include
wealth and target wealth, collateral effects, and changes in the interest
rate.
Investment
We have just seen that investment spending will be influenced by the
interest rate and the expected post-tax rate of profit. In the aggregate
investment function:
• Spending on investment is a function of the interest rate and the expec-
ted post-tax rate of profit.
• Ceteris paribus, a higher interest rate reduces investment spending,
shifting down the aggregate demand curve.
• A higher expected post-tax rate of profit raises investment spending,
shifting up the aggregate demand curve.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
610
exogenous Coming from outside
the model rather than being
produced by the workings of the
model itself. See also: endogenous.
marginal propensity to import The
change in total imports associated
with a change in total income.
exchange rate The number of units
of home currency that can be
exchanged for one unit of foreign
currency. For example, the number
of Australian dollars (AUD) needed
to buy one US dollar (USD) is
defined as number of AUD per USD.
An increase in this rate is a
depreciation of the AUD and a
decrease is an appreciation of the
AUD.
Government spending
Much of government spending (excluding transfers) is on general public
services, health, and education. Government spending does not change in a
systematic way with changes in income. It is referred to as exogenous.
An increase in government spending shifts the aggregate demand curve
up in the multiplier diagram.
Net exports
The home economy sells goods and services abroad, which are its exports.
The amount of foreign goods the home economy demands (its imports) will
depend on domestic incomes. The fraction of each additional unit of
income that is spent on imports is termed the marginal propensity to
import (m), which must be between 0 and 1. So we have:
If a country’s costs of production fall so that it can sell its goods at a lower
price on world markets compared to the prices of other countries, the
demand for its exports will increase, and domestic demand for imports will
fall. We will see in the next unit that the exchange rate affects the prices of
a country’s goods on world markets. Growth in world markets also
increases exports. For now, however, we will ignore these effects and
assume that exports are also exogenous.
Putting together each of the components of aggregate demand we have:
Both taxes and imports reduce the size of the multiplier. Recall that the
multiplier tells us the amount by which an increase in spending (such as a
rise in autonomous consumption, investment, government spending, or
exports) raises GDP in the economy. When we include taxation and imports
in the model, the indirect multiplier effect of a given rise in spending on
GDP is smaller. This is because some household income goes straight to the
government as taxation, and some is used to buy goods and services
produced abroad. Because we assume that the government does not
increase its spending when taxes go up, and foreign buyers do not import
more of our goods when we import more of theirs, this means that some of
an autonomous increase in income does not lead to further indirect
increases in income in the domestic economy. Like saving, taxation and
imports are referred to as leakages from the circular flow of income. The
result is to reduce the indirect effects of an autonomous change in spending
on aggregate demand, output, and employment.
To summarize:
• A higher marginal propensity to import reduces the size of the multiplier: This
makes the aggregate demand curve flatter.
• An increase in exports shifts the aggregate demand curve up in the multiplier
diagram.
• An increase in the tax rate reduces the size of the multiplier: This makes the
aggregate demand curve flatter.
14.5 THE MULTIPLIER MODEL: INCLUDING THE GOVERNMENT AND NET EXPORTS
611
The Einstein at the end of this section shows you how to calculate the size
of the multiplier in the model once the tax rate and imports are included.
To illustrate, we assume a tax rate of 20% (0.2) and a marginal propensity to
import of 0.1. Before we introduced the government, we set the marginal
propensity to consume, c1, at 0.6. If we use these numbers in the formula
for the multiplier that we calculate in the Einstein, we get the result that the
value of the multiplier is k = 1.6, compared to 2.5 without including
taxation and imports. In the next section we look at how economists have
estimated the size of the multiplier from data, why their estimates differ,
and why it matters.
EXERCISE 14.3 THE MULTIPLIER MODEL
Consider the multiplier model discussed above.
1. Compare two economies, which differ only in their share of credit-
constrained households but are identical otherwise. In which economy
is the multiplier larger? Illustrate your answer using a diagram.
2. On the basis of your comparison of the two economies, would you
expect the multiplier in an economy to vary over its business cycle?
3. Some economists estimated the size of the multiplier in the Great
Depression to be equal to 1.8. Explain how the following characteristics
of the US economy at the time could have affected its value:
(a) the size of government (see Figure 14.1)
(b) the fact that there were no unemployment benefits
(c) the fact that the share of imports was small
QUESTION 14.6 CHOOSE THE CORRECT ANSWER(S)
The aggregate demand of an open economy is given by the after-tax
domestic consumption C, the investment I (which depends on the
interest rate r), the government spending G and net exports X − M:
c0 is autonomous consumption, c1 is the marginal propensity to con-
sume, and m is the marginal propensity to import. In the economy’s
equilibrium this equals its output: AD = Y. Solving for Y yields:
Given this equation, which of the following increases the multiplier?
A fall in government spending.
A fall in the interest rate.
A fall in the marginal propensity to import.
A rise in the tax rate.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
612
EINSTEIN
The multiplier in an economy with a government and foreign
trade
We can again use the fact that there is equilibrium in the goods market
when output is equal to aggregate demand to find the multiplier (equi-
librium is where the aggregate demand line crosses the 45-degree line in
the multiplier diagram). The aggregate demand equation can be
rearranged to solve for output and consequently the multiplier:
Therefore:
We can see that the multiplier is smaller when we introduce the govern-
ment and foreign trade:
The reason is that the denominator on the left-hand side is larger than
on the right:
14.5 THE MULTIPLIER MODEL: INCLUDING THE GOVERNMENT AND NET EXPORTS
613
fiscal policy Changes in taxes or
government spending in order to
stabilize the economy. See also:
fiscal stimulus, fiscal multiplier,
aggregate demand.
co-insurance A means of pooling
savings across households in order
for a household to be able to
maintain consumption when it
experiences a temporary fall in
income or the need for greater
expenditure.
hidden actions (problem of) This
occurs when some action taken by
one party to an exchange is not
known or cannot be verified by the
other. For example, the employer
cannot know (or cannot verify) how
hard the worker she has employed
is actually working. Also known as:
moral hazard. See also: hidden
attributes (problem of).
••14.6 FISCAL POLICY: HOW GOVERNMENTS CAN
DAMPEN AND AMPLIFY FLUCTUATIONS
There are three main ways that government spending and taxation can
dampen fluctuations in the economy:
• The size of government: Unlike private investment, government spending
on consumption and investment is usually stable. Spending on health
and education, which are the two largest government budget items in
most countries, does not fluctuate with capacity utilization or with busi-
ness confidence. These kinds of government spending stabilize the
economy. As we have also seen, a higher tax rate dampens fluctuations
because it reduces the size of the multiplier.
• The government provides unemployment benefits: Although households save
to smooth fluctuations in income, few households save enough (that is,
self-insure) to cope with an extended period of unemployment. So unem-
ployment benefits help households to smooth consumption. Other pro-
grams to redistribute income to the poor have the same smoothing effect.
• The government can intervene: It can intervene deliberately to stabilize
aggregate demand using fiscal policy.
Could workers insure privately against job loss? There are also three
reasons why the private market fails, and therefore governments provide
unemployment insurance in the form of unemployment benefits:
• Correlated risk: In a recession, job loss will be widespread. This means
that there will be a surge in insurance claims across the economy and a
private provider may be unable to pay out on the scale required. It also
means co-insurance among a group of neighbours or family members
may be of limited use, as the need for help may arise in many households
at the same time.
• Hidden actions: As we saw in Unit 12, the insurance company cannot
observe the reason for the job loss so it would have to insure the
employee against a firm cutting back employment due to lack of
demand, as well as the worker being fired for inadequate work. This
creates a moral hazard, because a well-insured person is expected to
make less of an effort on the job.
• Hidden attributes: Suppose you learn that your firm is in difficulty, but
the insurance company does not. This is another example of
asymmetric information. You will therefore buy insurance when you
learn of the likely closure of the firm, and it will be provided at good
rates because the insurance company does not know that you are likely
to make a claim on them. Workers who know their firm is performing
well will not buy insurance. The hidden attributes problem will be true
about individuals (hardworking or lazy), as well as firms (successful or
failing). The good prospects (those who enjoy working hard, for
example) will shun the insurance and the insurer will be left with those
likely to face the extra risks of losing their job.
The system of unemployment benefits is part of the automatic
stabilization that characterizes modern economies. We have already seen
another automatic stabilizer: a proportional tax system reduces the size of
the multiplier and dampens the business cycle.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
614
moral hazard This term originated in the insurance industry to
express the problem that insurers face, namely, the person with
home insurance may take less care to avoid fires or other
damages to his home, thereby increasing the risk above what it
would be in absence of insurance. This term now refers to any
situation in which one party to an interaction is deciding on an
action that affects the profits or wellbeing of the other but
which the affected party cannot control by means of a contract,
often because the affected party does not have adequate
information on the action. It is also referred to as the ‘hidden
actions’ problem. See also: hidden actions (problems of),
incomplete contract, too big to fail.
hidden attributes (problem of) This occurs when some
attribute of the person engaging in an exchange (or the
product or service being provided) is not known to the other
parties. An example is that the individual purchasing health
insurance knows her own health status, but the insurance com-
pany does not. Also known as: adverse selection. See also:
hidden actions (problem of).
asymmetric information Information that is relevant to the
parties in an economic interaction, but is known by some but
not by others. See also: adverse selection, moral hazard.
automatic stabilizers Characteristics of the tax and transfer
system in an economy that have the effect of offsetting an
expansion or contraction of the economy. An example is the
unemployment benefits system.
paradox of thrift If a single individual consumes less, her
savings will increase; but if everyone consumes less, the result
may be lower rather than higher savings overall. The attempt
to increase saving is thwarted if an increase in the saving rate is
unmatched by an increase in investment (or other source of
aggregate demand such as government spending on goods and
services). The outcome is a reduction in aggregate demand and
lower output so that actual levels of saving do not increase.
fallacy of composition Mistaken inference that what is true of
the parts (for example a household) must be true of the whole
(in this case the economy as a whole). See also: paradox of
thrift.
In our list, the third role of government in
dampening fluctuations is the use of fiscal policy
in deliberate stabilization policies: an increase in
government spending or cuts in taxation to
support aggregate demand in a downturn; or
trimming spending and raising taxes to rein in a
boom. It can be cumbersome to have these fiscal
policy measures approved by a parliament, which
has power over budgetary decisions, which is one
reason why stabilization policy is often handled
through monetary, rather than fiscal, policy. But
fiscal policy can also play an important role in
stabilization, as we now consider, especially in
particularly large downturns.
The paradox of thrift and the fallacy of
composition
By comparing a household with the economy as a
whole, we better understand the nature of an
increase in the government’s deficit in a recession.
Faced with a household budget deficit, a family
worried about their falling wealth cuts spending
and saves more. We saw exactly this behaviour in
Figure 14.8 when households increased their
savings in 1929. Keynes showed that the wisdom
of family precautionary saving does not apply to
the government when the economy is in a
recession.
Compare the attempt to save more by a single
household and by all households in the economy
simultaneously. Think of a single household
cutting expenditures and putting its additional
savings in a sock. The money is in the sock for
when the household decides it is wise to spend it.
Now, assume that all households cut
expenditures and put additional savings in their
socks. Assuming nothing else in the economy
changes, the additional saving causes lower
aggregate consumption spending in the economy.
What happens? From the previous section, we can
model this as a fall in autonomous consumption,
c0: the aggregate demand curve shifts down. The economy moves through
the multiplier process to a lower level of output, income, and employment.
The aggregate attempt to increase savings led to a fall in aggregate income,
which is known as the paradox of thrift. The fact that what is true for one
part of the economy is not true of the whole economy is known as the
fallacy of composition.
A single household can increase its savings if it anticipates bad luck, and
the saving will be there if it is unlucky—for example, if someone becomes ill
or loses a job. However, if every household does this when the economy is
in a recession, this behaviour causes the bad luck: more people lose their
jobs. The reason is that in the economy as a whole, spending and earning go
together. My spending is your income. Your spending is my income.
14.6 FISCAL POLICY
615
fiscal stimulus The use by the gov-
ernment of fiscal policy (via a
combination of tax cuts and spend-
ing increases) with the intention of
increasing aggregate demand. See
also: fiscal multiplier, fiscal policy,
aggregate demand.
What can be done? The government can allow the automatic stabilizers
to operate and help absorb the shock. In addition, it can provide an eco-
nomic stimulus (such as a temporary increase in government spending or a
temporary cut in taxation) until business and consumer confidence return
and the private sector regains its willingness to spend. Budget deficits rise,
but this avoids a deep recession, as Keynes realized.
When a government cuts taxes or increases government spending G in a
recession, it is called a fiscal stimulus. The aim is to counteract the fall in
aggregate demand from the private sector. A tax cut is intended to
encourage the private sector to spend more, while an increase in G is a
direct addition to aggregate demand. Figure 14.11a shows how an increase
in G can offset a decline in private consumption, such as that described by
the paradox of thrift. Like an exogenous increase in investment, the rise in
G operates via the multiplier, so the increase in output will typically be
greater than the increase in G.
c0 + I(r) + G + X
c0′ + I(r) + G′ + X
Ag
gr
eg
at
e
de
m
an
d,
A
D
AD
45º
A AD (lower consumption, c0′
and higher government
spending, G′)
C
B
AD (lower level of
consumption, c0′)
c0′ + I(r) + G + X
Note: AD = c0 + c1(1 – t)Y+ I(r) + G+ X– mY
Output (income), Y
Y = AD on 45-degree line
Figure 14.11a Fiscal expansion can offset a decline in private consumption.
1. Goods market equilibrium
The economy starts at point A, in goods
market equilibrium, at which aggregate
demand is equal to output.
2. The economy moves into recession
This occurs after a fall in consumer
confidence, reducing c0. The aggregate
demand line shifts downward and the
economy moves from point A to point
B.
3. Fiscal stimulus: a rise in G
Suppose that the government then
increases spending, from G to G′, in
order to counteract the decline in
aggregate demand. AD shifts back up
and the economy moves to point C.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
616
John Maynard Keynes. 2005. The
Economic Consequences of the
Peace. New York, NY: Cosimo
Classics.
John Maynard Keynes. 1936. The
General Theory of Employment,
Interest and Money
(https://tinyco.re/6855346).
London: Palgrave Macmillan.
GREAT ECONOMISTS
John Maynard Keynes
John Maynard Keynes
(1883–1946) and the Great
Depression of the 1930s changed
the course of economic thought.
Until then, most economists had
seen unemployment as the result
of some kind of imperfection in
the labour market. If this market
worked optimally it would equate
the supply of, and demand for,
workers. The massive and
persistent unemployment in the
decade prior to the Second World
War led Keynes to look again at the problem of joblessness.
Keynes was born into an academic family in Cambridge, UK. He
studied mathematics at King’s College, Cambridge and then became an
economist and prominent follower of the renowned Cambridge
professor, Alfred Marshall. Before the First World War, Keynes was a
world authority on the quantity theory of money and the gold standard,
and held conservative views on economic policy, arguing for a limited
role of government. But his views would soon change.
In 1919, following the end of the First World War, Keynes published
The Economic Consequences of the Peace, which opposed the Versailles
settlement that ended the war. This book instantly made him a global
celebrity. Keynes rightly argued that Germany could not pay large
reparations for the war, and that an attempt to make Germany do this
would help provoke a worldwide economic crisis. In 1925, Keynes
opposed Britain’s return to the gold standard, arguing that this policy
would lead to a contraction of the economy. In 1929 there was a finan-
cial crash and global crisis. The Great Depression followed. In 1931
Britain was driven off the gold standard.
In response to these dramatic events, Keynes explained that the
orthodox monetary policies required by the gold standard would worsen
the depression, and that the world needed policies to increase aggregate
demand. In 1936, he published The General Theory of Employment, Interest
and Money in which he set out an economic model to explain these
views. The General Theory immediately became world famous,
particularly for the idea of the multiplier, which is explained in this unit.
In The General Theory, Keynes reasoned that if interest rates were
already very low, then fiscal expansion would be necessary to alleviate
depression. Such was the lasting influence of his work that the initial
response in many countries to the global economic crisis of 2008 was to
apply such Keynesian policies.
During the Second World War, Keynes turned to postwar
reconstruction, determined to ensure that the mistakes that followed the
First World War would not be repeated. In 1944, with Harry Dexter
White of the US, he led an international conference at Bretton Woods in
New Hampshire that resulted in the creation of a new international
monetary system, managed by the International Monetary Fund, or IMF.
14.6 FISCAL POLICY
617
John Maynard Keynes. 2004. The
End of Laissez-Faire. Amherst, NY:
Prometheus Books.
government budget balance The difference between govern-
ment tax revenue and government spending (including
government purchases of goods and services, investment
spending, and spending on transfers such as pensions and
unemployment benefits). See also: government budget deficit,
government budget surplus.
government budget deficit When the government budget
balance is negative. See also: government budget balance, gov-
ernment budget surplus.
government budget surplus When the government budget
balance is positive. See also: government budget balance, gov-
ernment budget deficit.
For my part I think that capitalism, wisely managed, can probably
be made more efficient for attaining economic ends than any
alternative system yet in sight, but that in itself it is in many ways
extremely objectionable. Our problem is to work out a social
organization which shall be as efficient as possible without
offending our notions of a satisfactory way of life.
How governments can amplify fluctuations
Keynes’ argument refers to the cell in the bottom right of Figure 14.12 at
the end of this section: poor policymaking that amplifies the business cycle.
Sometimes a government chooses to raise taxes
or cut spending during a recession because it is
concerned about the effect of a recession on its
budget balance. The government budget balance
is the difference between government revenue less
transfers, T, and government spending, G, that is,
(T − G). As we have seen, if the economy is in
recession, government transfers, like unemploy-
ment benefits, rise while tax revenues fall, so the
government’s budget balance deteriorates and
may become negative.
When the government’s budget balance is neg-
ative, this is called a government budget
deficit—government spending on goods and
services, including investment spending, plus
spending on transfers (such as pensions and unemployment benefits) is
greater than government tax revenue. A government budget surplus is
when tax revenue is greater than government spending. To summarize:
• Budget in balance: G = T
• Budget deficit: G > T
• Budget surplus: G < T
The Bretton Woods system was designed to avoid the mistakes Keynes
had unsuccessfully warned against in the aftermath of the First World
War, and to ensure that a country that was in recession (and had balance
of payments difficulties) would not need to follow the contractionary
policies required by the gold standard. A country like this could use
fiscal policy to pursue full employment, while at the same time it could
devalue its exchange rate to encourage exports, reduce imports, and
achieve a satisfactory balance of payments position.
Keynes led a remarkably varied life. He was an academic, a senior
civil servant, owner of the New Statesman magazine, financial speculator,
chairman of an insurance company, and member of the British House of
Lords. He was also the founder of the Arts Council of Great Britain and
chairman of the Covent Garden Opera Company. He was married to the
Russian ballerina Lydia Lopokova and was a key member of the
Bloomsbury Group, a remarkable circle of artistic and literary friends in
London, which included the novelist Virginia Woolf.
In 1926, in a pamphlet entitled The End of Laissez-Faire, he wrote:
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
618
The worsening of the government’s budgetary position in a recession is
part of its stabilizing role. Conversely, when the government chooses to
override the stabilizers to reduce its deficit, this may amplify fluctuations in
the economy.
Suppose a government tries to improve its budgetary position in a
recession by cutting its spending. This, like a tax increase, is referred to as
austerity policy. Follow the analysis in Figure 14.11b to see how austerity
policy can reinforce a recession by further reducing aggregate demand.
Does this argument mean that governments should never impose
austerity in order to reduce a fiscal deficit? No—just that a recession is not
a wise time to do it. Running government deficits under the wrong eco-
nomic conditions can be harmful. In a well-designed policy framework,
there will be constraints on government action, as we will see in
Section 14.8.
Ag
gr
eg
at
e
de
m
an
d,
A
D
AD
45º
A
AD (lower consumption, c0′
and lower government
spending, G′)
AD (lower level of
consumption, c0′)
C
Bc0 + I(r) + G+ X
c0′ + I(r) + G′+ X
c0′ + I(r) + G+ X
Note: AD = c0 + c1(1 – t)Y+ I(r) + G+ X– mY
Output (income), Y
Y = AD on 45-degree line
Figure 14.11b Government austerity can worsen a recession.
1. Goods market equilibrium
The economy starts at point A in goods
market equilibrium, at which aggregate
demand is equal to output.
2. The economy moves into recession
This occurs after a fall in consumer
confidence, reducing c0. The aggregate
demand line shifts downward and the
economy moves from point A to point
B.
3. Austerity policy
Suppose that the government then
reduces spending from G to G′, in a bid
to offset the deterioration of its budget
balance. The recession then feeds back
to raise government transfers and
reduce tax revenue.
14.6 FISCAL POLICY
619
negative feedback (process) A
process whereby some initial
change sets in motion a process
that dampens the initial change.
See also: positive feedback
(process).
positive feedback (process) A
process whereby some initial
change sets in motion a process
that magnifies the initial change.
See also: negative feedback
(process).
The table in Figure 14.12 summarizes the lessons so far. The first row
gives examples of how household behaviour may either smooth or disrupt
the economy. The terms negative and positive feedback are used to refer
to dampening and amplifying mechanisms in the business cycle.
EXERCISE 14.4 SPENDING CUTS IN A RECESSION
Assume the government is initially in budget balance.
1. Does the government’s budget balance improve, deteriorate, or remain
unchanged if the government cuts its spending in a recession, ceteris
paribus? To answer this question, use the example in Figure
14.11b (page 619). Assume the budget was in balance at point A. Once
at B, the government cuts G in an attempt to improve its budget
balance. Assume there are no unemployment benefits and a linear tax.
2. Evaluate the government’s policy.
QUESTION 14.7 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
Maintaining fiscal balance in a recession helps to stabilize the eco-
nomy.
Automatic stabilizers refer to the fact that economic shocks are
partly offset by households smoothing their consumption in the
face of variable income.
The multiplier on a fiscal stimulus is higher when the economy is
functioning at full capacity.
A fiscal stimulus can be implemented by raising spending to directly
increase demand, or by cutting taxes to increase private sector
demand.
Dampening mechanisms
offset shocks (stabilizing)
Amplifying mechanisms reinforce shocks (may be destabilizing)
Private sector
decisions
• Consumption
smoothing
• Credit constraints limit consumption smoothing
• Rising value of collateral (house prices) can increase wealth above the
target level and raise consumption
• Rising capacity utilization in a boom encourages investment spending,
adding to the boom
Government and
central bank
decisions
• Automatic stabilizers
(for example
unemployment bene-
fits)
• Stabilization policy
(fiscal or monetary)
• Policy mistakes such as limiting the scope of automatic stabilizers in a
recession or not running deficits during low demand periods while not
running surpluses during booms
Figure 14.12 The role of the private sector and the government in the business
cycle.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
620
CROWDING OUT
The effect of an increase in govern-
ment spending in reducing private
spending, as would be expected for
example in an economy working at
full capacity utilization, or when a
fiscal expansion is associated with
a rise in the interest rate.
crowding out There are two quite
distinct uses of the term. One is the
observed negative effect when eco-
nomic incentives displace people’s
ethical or other-regarding
motivations. In studies of individual
behaviour, incentives may have a
crowding out effect on social pref-
erences. A second use of the term is
to refer to the effect of an increase
in government spending in
reducing private spending, as
would be expected for example in
an economy working at full
capacity utilization, or when a
fiscal expansion is associated with
a rise in the interest rate.
•14.7 THE MULTIPLIER AND ECONOMIC POLICYMAKING
In the multiplier model, we have used simple ways of modelling aggregate
consumption, investment, trade, and government fiscal policy. This means
there are a small number of variables from which the size of the multiplier
is calculated (the marginal propensity to consume, the marginal propensity
to import, and the tax rate). When we apply the model to the real world, it is
important to realize that there is no single multiplier that applies at all
times.
The multiplier will be a different size if the economy is operating at full
capacity utilization and low unemployment than in a recession. With fully
employed resources, a 1% increase in government spending would displace
or crowd out some private spending in the economy. To consider an
extreme case, if all workers are employed, then an increase in government
employment can only come about by taking workers out of the private
sector. If increased government production were offset exactly by reduced
private sector production, then the multiplier would be zero.
We would not normally expect a government to undertake a fiscal
expansion when unemployment is very low—although it may in exceptional
circumstances like war, as the US did in the later years of the Second World
War and in the Vietnam War.
The size of the multiplier will also depend on the expectations of firms
and businesses. The economy is not like a bicycle tyre, from which air can
be pumped in or let out to keep the pressure at the right level. Households
and firms react to policy changes, but they also anticipate them. For
example, if firms anticipate that the government will stabilize the economy
following a negative shock, this will support business confidence, and the
policymaker will be able to use a smaller stimulus. Alternatively, if house-
holds think that higher government spending will be followed by higher
taxes, those who have the ability to save may put aside more of their money
to pay the extra taxes. If this happened, it would reduce the impact of the
stimulus.
When the financial crisis in 2008 led to the biggest fall in GDP in many
economies since the Great Depression, the world’s policymakers expected
an answer from economists: would fiscal policy help to stabilize the eco-
nomy? The multiplier model, inspired by Keynes’ analysis of the Great
Depression, suggested that it would. But by 2008, many economists
doubted that the Keynesian model was still relevant. The crisis has revived
interest in it and has led to a greater, though not complete, consensus
among economists about the size of the multiplier (see below).
In 2012 a study published by Alan Auerbach and Yuriy Gorodnichenko,
two economists, showed how the multiplier varies in size according to
whether the economy is in a recession or in an expansion. This is exactly
the insight that policymakers needed in 2008.
For the US, their study suggested a $1 increase in government spending
in the US raises output by about $1.50 to $2.00 in a recession, but only
about $0.50 in an expansion. Auerbach and Gorodnichenko extended their
research to other countries and found similar results. They also found that
the effect of autonomous increases in spending in one country had spillover
effects on the countries with which they trade. These effects were about the
same magnitude as the indirect effects of second, third, and further rounds
of spending in the home country.
This is a summary of the paper
published in 2012: Alan Auerbach
and Yuriy Gorodnichenko. 2015.
‘How Powerful Are Fiscal Multi-
pliers in Recessions?’
(https://tinyco.re/3018428). NBER
Reporter 2015 Research Summary.
14.7 THE MULTIPLIER AND ECONOMIC POLICYMAKING
621
Antonio Acconcia, Giancarlo
Corsetti, and Saverio Simonelli.
2014. ‘Mafia and Public Spending:
Evidence on the Fiscal Multiplier
from a Quasi-Experiment’.
American Economic Review 104 (7)
(July): pp. 2185–2209.
natural experiment An empirical
study exploiting naturally occurring
statistical controls in which
researchers do not have the ability
to assign participants to treatment
and control groups, as is the case in
conventional experiments. Instead,
differences in law, policy, weather,
or other events can offer the
opportunity to analyse populations
as if they had been part of an
experiment. The validity of such
studies depends on the premise
that the assignment of subjects to
the naturally occurring treatment
and control groups can be
plausibly argued to be random.
reverse causality A two-way causal
relationship in which A affects B
and B also affects A. Proximity to
the Mafia
Replacement
by technocrats
Spending
cuts
Variation in
output
Figure 14.13 Using Mafia proximity to estimate the multiplier.
HOW ECONOMISTS LEARN FROM FACTS
The Mafia and the multiplier
It may surprise you that economists have used the Italian government’s
struggle against the Mafia to uncover the size of the multiplier, but that’s
what Antonio Acconcia, Giancarlo Corsetti, and Saverio Simonelli were
able to do. Adopting the natural experiment method to address the
problem of reverse causality, they used data on Mafia-related
dismissals of local politicians to isolate the variation in public spending
that is not caused by variations in output.
After legal changes in 1991, the central government dismissed
provincial councils in Italy who were revealed to have close links with
the Mafia, and appointed new officials in their place. These technocrats
cut local spending by 20% on average. The change in public spending
occurred because of the Mafia links, through their effect on the
replacement of government officials. And because there is no direct
causal link from proximity to the Mafia to the variation in output,
proximity to the Mafia can be used to uncover the causal effect of a
change in public spending on output. This situation is illustrated in
Figure 14.13.
Using this method, the researchers were able to estimate multipliers of
1.5 at the local level.
Economists have used their ingenuity to come up with methods of
estimating the size of the multiplier and the implication of its operation
for jobs. Using the US stimulus program that was implemented in the
wake of the financial crisis (the American Recovery and Reinvestment
Act of 2009 (https://tinyco.re/7003843), a $787 billion fiscal stimulus),
we would expect that US states that were more severely hit by the finan-
cial crisis would have had higher unemployment and attracted more
stimulus spending by the government. So unemployment causes more
spending in those states. This makes it difficult to estimate the effect of
higher spending on output and unemployment, which is what we want
to do if we want to know the size of the multiplier.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
622
Sylvain Leduc and Daniel Wilson.
2015. ‘Are State Governments
Roadblocks to Federal Stimulus?
Evidence on the Flypaper Effect of
Highway Grants in the 2009
Recovery Act’ (https://tinyco.re/
3885744). Federal Reserve Bank of
San Francisco Working Paper
2013–16 (September).
The debate continues. Here are
some easily available resources:
Miguel Almunia, Agustín Bénétrix,
Barry Eichengreen, Kevin H.
O’Rourke, and Gisela Rua. 2010.
‘From Great Depression to Great
Credit Crisis: Similarities, Differ-
ences and Lessons.’ Economic
Policy 25 (62) (April): pp. 219–65.
Tim Harford. 2010. ‘Stimulus
Spending Might Not Be as
Stimulating as We Think’
(https://tinyco.re/9500536). Finan-
cial Times.
Paul Krugman. 2012. ‘A Tragic
Vindication’ (https://tinyco.re/
6611089). Paul Krugman – New
York Times Blog. Updated 9
October 2012.
Jonathan Portes. 2012. ‘What
Explains Poor Growth in the UK?
The IMF Thinks It’s Fiscal Policy’
(https://tinyco.re/8763401).
National Institute of Economic and
Social Research Blog. Updated 9
October 2012.
Noah Smith. 2013. ‘Why the Multi-
plier Doesn’t Matter’
(https://tinyco.re/7260376).
Noahpinion. Updated 7 January
2013.
Simon Wren-Lewis. 2012. ‘Multi-
plier Theory: One Is the Magic
Number’ (https://tinyco.re/
7820994). Mainly Macro. Updated
24 August 2012.
More miles
of highway
More stimulus
spending
Change in
unemployment
Figure 14.14 Using US stimulus highway spending to estimate the multiplier.
One approach to get around this problem of reverse causality is to
make use of the fact that some of the spending in the US stimulus
program was distributed to US states using a formula that was unrelated
to the severity of the recession experienced in each state. For example,
some road-repair expenditures funded by the stimulus package were
based on the length of highway in each state.
Given the formula for allocating road-building funds and the fact
that more miles of highway has no direct effect on the change in
unemployment, this allows us to answer the question: were more jobs
created in states that received more stimulus spending?
The results of studies using this approach estimated a multiplier of 2,
and suggest that the American Recovery and Reinvestment Act created
between 1 million and 3 million new jobs.
In spite of scepticism among some economists before the 2008 crisis
that the multiplier was greater than one, policymakers around the world
embarked on fiscal stimulus programs in 2008–09. Fiscal stimulus was
credited with helping to avert another Great Depression, as we will see
in Unit 17.
WHEN ECONOMISTS DISAGREE
How responsive is the economy to government spending?
There are few questions in economic policy discussed as heatedly in the
years since the financial crisis in 2008 as the size of the fiscal multiplier:
what is the effect on GDP of a 1% increase in government spending?
Much of the heat is generated by political differences among those
involved. People who favour greater government expenditure tend to
think the multiplier is large, while those who would like a smaller gov-
ernment tend to think that it is small. (We don’t know whether this
correlation is because their beliefs about government influence their
estimates of the size of the multiplier, or the other way round.)
This debate has been going on since the first theoretical
formalization of the multiplier by John Maynard Keynes in the 1930s.
The recent economic crisis has revitalized it for two reasons:
1. Monetary policy could not be used: Following the financial crisis, several
major economies remained in recession despite central banks cutting
interest rates to very close to zero. As we will see in the next unit,
interest rates cannot be cut below zero, so governments wanted to
14.7 THE MULTIPLIER AND ECONOMIC POLICYMAKING
623
International Monetary Fund. 2012.
World Economic Outlook October:
Coping with High Debt and
Sluggish Growth (https://tinyco.re/
5970823).
Robert J. Barro. 2009. ‘Government
Spending Is No Free Lunch.’ The
Wall Street Journal.
Paul Krugman. 2009. ‘War and Non-
Remembrance’ (https://tinyco.re/
8410113). Paul Krugman – New
York Times Blog.
know if the fiscal stimulus of an increase in government spending
would help stabilize the economy.
2. Arguments about whether austerity works: After the Eurozone crisis in
2010, many European countries that were in recession adopted
austerity measures of cutting government spending, with the
objective of bringing their public finances back to balance.
In both stimulus and austerity, the success of the policy depends on the
size of the multiplier. If the multiplier is negative—which could happen
if a rising fiscal deficit causes a large reduction in confidence—a
stimulus package would lead to a reduction in GDP, and an austerity
policy would cause GDP to rise. If the multiplier is positive but less than
1, a fiscal stimulus would raise GDP but by less than the increase in gov-
ernment spending. If, as in our multiplier model, the multiplier is greater
than 1, a fiscal stimulus would raise GDP by more than the increase in
government spending and a policy of austerity would reinforce the
recession conditions.
Depending on methodologies and assumptions, economists have put
forward different estimates of multipliers, from negative numbers to
values greater than 2. For instance, members of President Obama’s
Council of Economic Advisors estimated the multiplier as 1.6 when they
prepared the American Recovery and Reinvestment Act of 2009. The
International Monetary Fund presented estimates in 2012 that multi-
pliers in advanced economies were, after the crisis, between 0.9 and 1.7.
To be effective, government spending needs to put resources that
would otherwise be idle into productive use. These resources can be
unemployed (or underemployed) workers, as well as offices, shops, or
factories functioning with spare capacity. When an economy functions
at full capacity (with no idle resources), extra government spending will
crowd out private spending.
Robert Barro and Paul Krugman, the economists, disagreed about the
size of the multiplier in the weeks that followed the enactment of the
American Recovery and Reinvestment Act in early 2009. Using data on
government defence spending during the Second World War, Barro
concluded that the multiplier was not larger than 0.8. That is, spending
$1 on military equipment yielded only 80 cents of output. However,
Krugman responded that in wartime there are no idle productive
resources to take advantage of. People of working age were in work
supporting the war effort in factories, and the government used
rationing to depress private consumption.
In the recessions that followed the Eurozone crisis in 2010, just as
new economic research was finding evidence that multipliers in
recessions were well above one, many European governments
implemented fiscal austerity to balance their budgets. These countries
had poor growth outcomes—another sign that, in deep recessions, the
multiplier is greater than one. But some Eurozone countries had no
choice but to adopt austerity policies. As we will see in the next section,
they had lost the ability to borrow.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
624
EXERCISE 14.5 METHODS TO ESTIMATE THE MULTIPLIER
Consider the three methods discussed in this unit that have been used to
estimate the size of the multiplier: the Mafia-related dismissals in Italy, the
stimulus highway spending in the US, and wartime defence spending in the
US.
Why do you think estimates of the size of the multiplier vary? Use the
material in this unit to support your explanation.
EXERCISE 14.6 CONTRIBUTIONS TO CHANGE IN REAL
GROSS DOMESTIC PRODUCT OVER THE BUSINESS
CYCLE
In the table in Figure 13.8 (page 561) we showed the
contributions of the main components of expenditure
(C, I, G, and X − M) made to US GDP growth during the
recession of 2009. We can use FRED to see whether
these contributions changed during the recovery phase
of the recession.
Go to the FRED website (https://tinyco.re/5104028).
You can watch this short tutorial (https://tinyco.re/
3209844) to understand how FRED works. Search for
‘Contribution to GDP’ using the search bar, and select
this annual series:
• Contributions to percentage change in real gross
domestic product: Personal consumption
expenditures
Make sure the frequency is quarterly. To change the
frequency of your series, click the ‘Edit graph’ button
above the top-right corner of the graph.
This button also allows you to add other series to
your graph. Click on ‘Add line’ and search for the
following series:
• Contributions to percentage change in real gross
domestic product: Gross private domestic invest-
ment
• Contributions to percentage change in real gross
domestic product: Government consumption
expenditures and gross investment
• Contributions to percentage change in real gross
domestic product: Net exports of goods and services
Finally, add a series for real GDP (‘Real Gross Domestic
Product’). Make sure you select quarterly frequency for
all series on your graph.
1. Do the contributions to GDP add up approximately
to the growth of GDP?
Now use the data you have downloaded to carry out
the following tasks for the period from 2007 to 2014:
2. Describe the contributions to US GDP growth in the
recession (2008 Q1 to 2009 Q2) and in the recovery
phase from 2009 Q3 of the business cycle. If you
analyse the data using the FRED graph, you will see
the recession shaded in the chart. Prepare a table
like the one in Figure 13.8 (page 561).
3. What might explain the differences seen in the role
of consumption and investment during the recession
and recovery phases of the business cycle?
4. From the contribution to GDP growth of government
consumption and investment expenditure, what can
you infer about the US government’s fiscal policy
during the crisis?
Note: To make sure you understand how these FRED
graphs are created, you may want to extract the data
into your spreadsheet and reproduce the series.
14.7 THE MULTIPLIER AND ECONOMIC POLICYMAKING
625
EXERCISE 14.7 THE FALL OF FRANCE
In an article from August 2014, ‘The Fall of France’ (https://tinyco.re/
7111032), Paul Krugman criticizes the austerity policy implemented in
France.
Use what you have learned about the fiscal multiplier to explain why,
in Krugman’s opinion, fiscal austerity in France (and more generally in
Europe) would fail (explain carefully what you think Krugman means by
‘fail’).
EXERCISE 14.8 STIMULUS WITHOUT MORE DEBT
Read ‘Stimulus, Without More Debt’ (https://tinyco.re/9857908) by Robert
Shiller.
Assume the economy is in a recession. The government has a high level
of debt and wants to set a balanced budget, that is, G = T. How can the
government achieve a fiscal stimulus effect on GDP whilst keeping the
budget balanced?
To answer the question, take the following steps:
• Show how this is possible in a multiplier diagram, ensuring that you
label the relevant intercepts and angles. Make the diagram sufficiently
accurate so that the exact size of the multiplier is visible.
• Explain in words how the government can achieve such a fiscal
stimulus effect whilst keeping the budget balanced.
• Derive the balanced budget multiplier using algebra. (Hint: You will
need to write down expressions for the change in GDP associated with
a change in both G and T and set these equal to each other.)
• Comment briefly on any disadvantages you see with the use of this
balanced budget fiscal stimulus.
You can make the following assumptions:
• Assume a lump sum tax. This means that the tax does not depend on
the level of income, T = T, rather than our usual assumption that T = tY.
• Also assume that the country does not have any imports or exports.
QUESTION 14.8 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct regarding the multiplier?
Economists tend to agree on their estimates of the multiplier.
Reverse causation can be a problem when estimating the multiplier
empirically.
If households anticipate that increased government spending will
be funded by future tax increases, then the multiplier will be higher.
If firms anticipate that the government’s fiscal policy will be
effective, then the multiplier will be higher.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
626
government debt The total amount
of money owed by the government
at a specific point in time.
primary deficit The government
deficit (its revenue minus its
expenditure) excluding interest
payments on its debt. See also: gov-
ernment debt.
sovereign debt crisis A situation in
which government bonds come to
be considered so risky that the gov-
ernment may not be able to
continue to borrow. If so, the gov-
ernment cannot spend more than
the tax revenue they receive.
•••14.8 THE GOVERNMENT’S FINANCES
From the paradox of thrift, we learned that in a recession, it is
counterproductive for the government to offset the automatic stabilization
of the economy. We have also learned that using a fiscal stimulus to boost
aggregate demand in a deep recession can be justified, under conditions in
which the multiplier is greater than one. So why are stimulus policies often
followed by policies of austerity? The answer is the government’s debt. To
understand why, we turn to the government’s revenue and its expenditure.
Revenue
Governments raise revenue in the form of income taxes and taxes on spend-
ing, often called Value Added Tax (VAT) or sales tax. They also raise money
from a variety of other sources including taxes on products like alcohol,
tobacco, and petrol—and on wealth, including through inheritance taxes.
Expenditure
Government expenditure includes health, education, and defence, as well as
public investment such as roads and schools.
Government revenue is also used to fund social security transfers, which
include unemployment benefits, pensions, and disability benefits. The gov-
ernment also has to pay interest on its debt. Transfers and interest
payments are paid out of government revenues, but they do not count in G
because the government is not spending money on goods or services.
Government primary deficit
The government deficit, excluding interest payments on its debt, is called
the primary budget deficit and is measured by G − T, where T is tax
revenue minus transfers (assumed to be tY in the multiplier model with a
proportional tax rate, t). If the initial situation is one of a zero primary deficit,
then it automatically worsens in a business cycle downturn. When the
downturn reverses, the government’s primary budget deficit will decline, and
in the upswing, the government will have higher revenues than spending.
When there is a budget deficit, this means the government must borrow
to cover the gap between its revenue and its expenditure. The government
borrows by selling bonds. Firms and households buy the bonds. Households
usually buy them indirectly, because they are bought by pension funds,
from which households buy pensions. The sale of bonds adds to the govern-
ment’s debt.
Because of the existence of global financial markets, foreigners can also
buy home country bonds. Government bonds are attractive to investors
because they pay a fixed interest rate and because they are generally con-
sidered a safe investment: the default risk on government bonds is usually
low. Investors are likely to want to hold a mixture of safe and risky assets,
and government bonds are normally at the safe end of the spectrum.
A sovereign debt crisis is a situation in which government bonds come
to be considered risky. Such crises are not uncommon in developing and
emerging economies, but they are rare in advanced economies. However, in
2010, there was an increase in interest rates on bonds issued by the Irish,
Greek, Spanish, and Portuguese governments, which was a signal of a sharp
increase in default risk—the likelihood that the government would be
unable to make the required payments on its debt. It marked the start of the
Eurozone crisis. Governments of countries experiencing a sovereign debt
14.8 THE GOVERNMENT’S FINANCES
627
crisis may have no alternative to austerity policies if they can no longer
borrow, because in this case they cannot spend more than the tax revenue
they receive.
A large stock of debt relative to GDP can be a problem because, like a
household, the government has to pay interest on its debt and it has to raise
revenue to pay the interest, which may require raising tax rates. However,
governments are not like households in that there is no point at which they
need to have paid off all their stock of debt—as one set of bonds matures,
governments will typically issue more bonds, maintaining a stock of debt
(this is called rolling over debt, which firms also typically do to finance their
operations). Indeed, because government bonds are generally seen as a safe
asset outside periods of crisis, there is usually demand for government debt
from private investors. As the long-run data for the UK in Figure 14.15
makes clear, there are no general rules about how much debt is safe for gov-
ernments to have.
Figure 14.15 shows the path of UK government debt from 1700 to 2020.
The level of indebtedness of a government is measured in relation to the
size of the economy, that is, as a percentage of GDP. The two big upward
spikes in the British debt to GDP ratio in the twentieth century were caused
by the need for the government to borrow to finance the war effort.
Financial crises also raise government debt. Governments borrow both
to bail out failing banks and to support the economy in the lengthy
recessions that follow financial crises. The UK’s debt-to-GDP ratio rapidly
doubled to more than 80% after the 2008 global financial crisis and
surpassed 100% in response to the COVID-19 pandemic.
Note also that, although the UK government emerged from the Second
World War with a very high level of debt, it fell rapidly in the following
decades: from 260% of GDP to 50% by the 1980s. Why? The British govern-
ment ran a primary budget surplus in every year except one from 1948
until 1973, which helped to reduce the debt-to-GDP ratio. But the ratio
may also fall even when there is a primary budget deficit, as long as the
growth rate of the economy is higher than the interest rate. During the
period of rapid reduction of the British debt ratio, in addition to the
0
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Figure 14.15 UK government debt as a percentage of GDP (1700–2020).
View this data at OWiD https://tinyco.re/
8971982
Ryland Thomas and Nicholas Dimsdale.
(2017). ‘A Millennium of UK Data’
(https://tinyco.re/0223548). Bank of
England OBRA dataset; UK Office for
National Statistics. (2021). Government
deficit and debt return (https://tinyco.re/
95037832).
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
628
Pareto improvement A change that
benefits at least one person
without making anyone else worse
off. See also: Pareto dominant.
fairness A way to evaluate an
allocation based on one’s
conception of justice.
primary surpluses, there was moderate growth, low nominal interest rates
set by the government, and moderate inflation.
Why does inflation help a country reduce its debt ratio? Because the face
value of government bonds (the level of debt) is denominated in nominal
terms. For instance, the issue of 10-year bonds in 1950 would promise to
repay £1 million in 1960. So if inflation was moderately high during the
1950s, then nominal GDP would be growing fast while that £1 million
owed in 1960 would remain constant, meaning the debt would have shrunk
relative to GDP. As we discuss further in Unit 15, inflation reduces the real
value of debt.
For many advanced economies, there have been extended periods in
which the growth rate has been higher than the interest rate. Brad DeLong,
an economist, has pointed out that this has been true for the US for almost
all of the last 125 years.
EXERCISE 14.9 EFFICIENCY AND FAIRNESS
How would you use the criteria of Pareto improvement and fairness to
evaluate the use of stimulus policies and bank bailouts following the
global financial crisis of 2007–2008?
Hint: you might want to look back at Sections 5.2 and 5.3 in Unit 5,
where the concepts are explained.
Countries with aging populations have demographic trends that imply
upward pressure on the debt-to-GDP ratio, because the proportion of gov-
ernment revenue spent on state pensions, healthcare, and social care for the
elderly will increase. Many governments and voters are facing a difficult
choice: do they limit benefits, or put up taxes?
The lessons from our discussion of fiscal policy and government debt
are:
• Automatic stabilizers play a useful role: Over the course of the business
cycle, they contribute to economic wellbeing.
• If additional fiscal stimulus is used, this ought to be reversed later: This
reversal can take place when the economy is growing again. If a stimulus
is not reversed, the government debt-to-GDP ratio will rise.
• Financial crises and wars increase government debt.
• Inflation reduces the debt burden of the government: Likewise, deflation
increases it.
• An ever-increasing debt ratio is unsustainable: But there is no rule that says
exactly how much debt is problematic.
• If the growth rate is below the interest rate, it is necessary to run primary gov-
ernment surpluses as they stabilize and reduce the debt ratio: Attempting to
reduce the debt ratio rapidly, however, is counterproductive if it
depresses growth.
To get a feel for the effects of policy interventions, The Economist provides a
modelling tool (https://tinyco.re/3107039) to experiment as a hypothetical
policymaker. Try different combinations of primary budget balance, growth
rate, nominal interest rate, and inflation rate as methods of preventing the
debt ratio from continuously rising in a country of your choice.
Bradford DeLong. 2015. ‘Draft for
Rethinking Macroeconomics
Conference Fiscal Policy Panel’
(https://tinyco.re/4631043).
Washington Center for Equitable
Growth. Updated 5 April 2015.
‘A Load to Bear’ (https://tinyco.re/
9740912). The Economist. Updated
26 November 2009.
14.8 THE GOVERNMENT’S FINANCES
629
••14.9 FISCAL POLICY AND THE REST OF THE WORLD
In Unit 13 we saw that agrarian economies suffered shocks from wars,
disease, and the weather. In Unit 11, we saw that the American Civil War
affected economies including Brazil, India and the UK. In modern eco-
nomies, what happens in the rest of the world is a source of shocks, and also
affects how domestic economic policy works. To avoid making mistakes,
policymakers need to know about these interactions.
Foreign markets matter
Fluctuations in growth in important markets abroad can explain why the
economy moves into an upswing or downswing: this is a change in the net
export component of aggregate demand, that is, (X − M). China, for
example, is a very important market for Australian exports (32% of
Australian exports went to China in 2013, accounting for 6.5% of
Australian aggregate demand). When the Chinese economy slowed down
from a growth rate of 10.6% in 2010 to 7.8% in 2013, this was transmitted
directly to a slowdown in growth in Australia via a fall in net exports.
Similarly, the slowdown in the Eurozone because of the 2010 crisis that
followed the 2008 global financial crisis, was an important reason for the
sluggishness of the British economy’s exit from recession. This is because a
high proportion of UK exports go to the EU. For example, 44% of the UK’s
exports went to the EU in 2013, accounting for 13% of UK aggregate
demand.
Imports dampen domestic fluctuations
As we have seen, the size of the multiplier is reduced by the marginal
propensity to import. When autonomous demand goes up, it stimulates
spending, and some of the products bought are produced abroad. This
dampens the domestic upswing.
Trade constrains the use of fiscal stimulus
Trade with other countries constrains the ability of domestic fiscal policy-
makers to use stimulus policies in a recession. A striking example comes
from France in the 1980s. At the start of the 1980s, the French economy
remained weak following the oil shocks of the 1970s, which disrupted the
world economy. In 1981, the socialist candidate François Mitterrand won
the presidential election. His appointed prime minister, Pierre Mauroy,
implemented a program to stimulate aggregate demand through increased
government spending and tax cuts (in the multiplier model, this is a rise in
G and a fall in t, the tax rate).
In Figure 14.16, we show what happened in France and in its biggest
trading partner, Germany. The purple bars show the outcomes for France
and the orange bars show the outcomes for Germany. The figure presents
the outcomes for three years. In the first year, there was no stimulus, in the
second, there was a fiscal stimulus in France, and the third year was the year
following the stimulus.
If you look at Figure 14.16, you will see that the budget balance in
France (measured as (T − G)/Y) becomes negative. We can read this as
saying that from a balanced budget in 1980, there was a budget deficit of
nearly 3% of GDP in 1982, which increased further by 1983.
Meanwhile, in Germany, the budget remained close to balance through
the three years. The budget surpluses were 0%, 0%, and 0.2% respectively.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
630
The expansionary demand policy in France was an exception in Europe.
There was an initial boost to French growth in 1982 (from 1.6% to 2.4%)
but it quickly vanished, with growth falling back to 1.2% in 1983. Why?
The upturn in the French economy led French households to increase
their spending, but much of this was on foreign goods. The French stimulus
spilled over to countries that produced more competitive products, like
Japan (electronic goods) and Germany (cars). There was a surge of imports
into France: measured relative to the level in 1979, imports were higher by
17.9%, as shown in Figure 14.16. Germany’s exports were higher by 17.1%
in 1982 and by nearly 14% in 1983. As a result, GDP growth was higher in
Germany than in France in 1983. The French stimulus policy mostly bene-
fitted its trading partners who had more competitive goods. France slipped
behind the pack of European countries, with lower growth and a high gov-
ernment budget deficit (above 3% in 1983).
The failure of Mitterrand’s policy was reflected in economic terms by
pressure on the French franc (the unit of currency during the period).
Between 1981 and 1983, the French government had to devalue the franc
three times in an effort to make French goods more competitive with those
produced abroad. Mauroy stepped down in 1984 and the new prime
minister introduced an austerity policy.
The Mitterrand experiment highlights the limits of using a fiscal
stimulus to successfully stabilize a deep recession. In the case of France, the
policy was badly designed and it delayed the adjustment of the French eco-
nomy to the shocks that had affected it in the 1970s. Note that the problem
in France was not only high unemployment. Injecting more aggregate
demand stimulated spending, but not spending on French output.
The multiplier was very low and the spillover effects to other economies
meant that most of the stimulus leaked out of France. Had the major Euro-
pean economies adopted fiscal expansionary policies simultaneously the
results would have been different, as the spillover effects of Germany, say,
would have stimulated the French economy. This is an example of poor
policymaking due to a failure to understand the country’s links with the
rest of the world. It would fit in the final row of the third column in Figure
14.12 (page 620).
A fiscal stimulus may not be the
only (or best) policy option in a
recession: Olivier Blanchard, the
former chief economist of the IMF,
explains how fiscal consolidation
worked in the case of Latvia in
2008, even though he had initially
advised against it.
Olivier Blanchard. 2012. ‘Lessons
from Latvia’ (https://tinyco.re/
8173211). IMFdirect – The IMF
Blog. Updated 11 June 2012.
Germany
France
No stimulus (1980)
French stimulus (1982)
Post stimulus (1983)
Budget balance (T – G) (ratio of GDP)
GDP growth rate (%)
Growth rate of exports (relative to 1979) (%)
Growth rate of imports (relative to 1979) (%)
Budget balance (T – G) (ratio of GDP)
GDP growth rate (%)
Growth rate of exports (relative to 1979) (%)
Growth rate of imports (relative to 1979) (%)
Budget balance (T – G) (ratio of GDP)
GDP growth rate (%)
Growth rate of exports (relative to 1979) (%)
Growth rate of imports (relative to 1979) (%)
−5 0 5 10 15 20
Figure 14.16 Successes and failures of the French fiscal stimulus (1980–1983).
OECD. 2015. OECD Statistics
(https://tinyco.re/9377362).
14.9 FISCAL POLICY AND THE REST OF THE WORLD
631
coordination game A game in
which there are two Nash
equilibria, of which one may be
Pareto superior to the other. Also
known as: assurance game.
supply side (aggregate economy)
How labour and capital are used to
produce goods and services. It uses
the labour market model (also
referred to as the wage-setting
curve and price-setting curve
model). See also: demand side
(aggregate economy).
demand side (aggregate economy)
How spending decisions generate
demand for goods and services,
and as a result, employment and
output. It uses the multiplier model.
See also: supply side (aggregate
economy).
multiplier model A model of
aggregate demand that includes
the multiplier process. See also:
fiscal multiplier, multiplier process.
EXERCISE 14.10 COORDINATING A STIMULUS
Assume the world is made up of just two countries, or blocs, called North
and South. The world is in a deep recession. The situation can be described
using the coordination game used for investment in Unit 13. Here the two
strategies are Stimulus and No stimulus.
Explain in words how the coordination game reflects the problems
faced by policymakers in the two countries that arise because of their
interdependence.
QUESTION 14.9 CHOOSE THE CORRECT ANSWER(S)
Figure 14.16 (page 631) shows the effects of France’s increased govern-
ment spending and tax cuts in 1982 on the economies of France and
Germany.
Based on this information, which of the following statements are
correct?
The French budget balance worsened by more than 3% as a result
of the fiscal expansion.
The fiscal expansion successfully resulted in a long-run shift in the
French GDP growth rate to above 2%.
The German economy benefitted from the spillover effect of higher
French imports of German goods.
Fiscal expansionary policy should never be adopted by European
economies, as they have high levels of trade with each other.
•14.10 AGGREGATE DEMAND AND UNEMPLOYMENT
We now have two models for thinking about total output, employment, and
the unemployment rate in the economy:
• The supply side (labour market) model: One model, set out in Unit 9, is of
the supply side of the economy and focuses on how labour is employed
to produce goods and services. This is called the labour market model
(or the wage-setting curve and price-setting curve model).
• The demand side (multiplier) model: The other is of the demand side of
the economy and explains how spending decisions generate demand for
goods and services and, as a result, employment and output. This is the
multiplier model.
When we put the models together, we will be able to explain how the eco-
nomy fluctuates around the long-run labour market equilibrium over the
business cycle.
The labour market model from Unit 9 is shown in Figure 14.17, and the
equilibrium in the labour market is where the wage- and price-setting
curves intersect. We will see that the economy tends to fluctuate over the
business cycle around the unemployment rate shown at point A. In the
example in Figure 14.17, the unemployment rate at equilibrium is 5%.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
632
production function A graphical or
mathematical expression
describing the amount of output
that can be produced by any given
amount or combination of input(s).
The function describes differing
technologies capable of producing
the same thing.
cyclical unemployment The
increase in unemployment above
equilibrium unemployment caused
by a fall in aggregate demand
associated with the business cycle.
Also known as: demand-deficient
unemployment. See also: equilib-
rium unemployment.
short run (model) The term does
not refer to a period of time, but
instead to what is exogenous:
prices, wages, the capital stock,
technology, institutions. See also:
wages, capital, technology, institu-
tions, medium run (model), long run
(model).
Figure 14.18 places the multiplier diagram beneath the labour market
diagram. Note that in the labour market diagram, the horizontal axis
measures the number of workers, so we can measure employment and
unemployment along it. In the multiplier diagram, output is on the hori-
zontal axis. The production function connects employment and output,
and in this model, the production function is very simple.
We assume that labour productivity is constant and equal to λ (‘lambda’),
so the production function is:
To allow us to draw the demand-side model underneath the supply-side
model, we assume λ = 1, and so Y = N.
Short-term fluctuations in employment are caused by changes in
aggregate demand. As we saw in Unit 9, when employment is below the
labour market equilibrium because of deficient aggregate demand, the addi-
tional unemployment is called cyclical unemployment. If there is excess
demand, above labour market equilibrium, then unemployment is below its
equilibrium level.
In Figure 14.19, the economy is initially at labour market equilibrium at
point A with unemployment of 5%. The level of output here is called the
normal level of output. This means that the level of aggregate demand must
be as shown by the aggregate demand curve labelled ‘normal’. Any other
level of aggregate demand would produce a different level of employment.
In our study of business cycle fluctuations using the multiplier model,
we have made a number of ceteris paribus assumptions. We have assumed
that prices, wages, the capital stock, technology, and institutions are
constant. We use the term short run to refer to these assumptions. The
purpose of the model is to predict what happens to output, aggregate
demand, and employment when there is a demand shock (a shock to
Workers (millions)
Wage-setting curve
Re
al
w
ag
e
Labour supply
Labour productivity
Price-setting curve
A
9.5 10
Employed Unemployed (U rate = 5%)
8.5
Figure 14.17 The supply side of the aggregate economy: The labour market.
14.10 AGGREGATE DEMAND AND UNEMPLOYMENT
633
medium run (model) The term does not refer to a period of
time, but instead to what is exogenous. In this case capital
stock, technology, and institutions are exogenous. Output,
employment, prices, and wages are endogenous. See also:
capital goods, technology, institution, short run (model), long
run (model).
investment, consumption or exports), or when policymakers use fiscal
policy or monetary policy to shift the aggregate demand curve.
Notice that in Figure 14.19, the labour market
is not in equilibrium when output is higher or
lower than normal. The labour market model is a
medium-run model where wages and prices can
change, unlike in the multiplier model, which is a
short-run model. So a short-run equilibrium in
the multiplier model may not be a medium-run
equilibrium in the labour market model.
Employment, N
Wage-setting curve
Re
al
w
ag
e
Supply side (medium and long run)
Labour supply
Labour productivity
Price-setting curve
A
9.5 108.5
Output, Y
45º
Ag
gr
eg
at
e
de
m
an
d,
A
D
Demand side (short run)
AD (high)
AD (normal)
A
B
C
AD (low)
normal
recession boom
Figure 14.18 The supply side and the demand side of the aggregate economy.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
634
Wage-setting curve
Re
al
w
ag
e
Supply side (medium & long run)
Labour supply
Labour productivity
Price-setting curve
AC
45º
Ag
gr
eg
at
e
de
m
an
d,
A
D
Demand side (short run)
AD (high)
AD (normal)
A
C
AD (low)
normal
recession
Shifts in aggregate demand
cause cyclical fluctuations
in unemployment
boom
B
B
Employment, N
Output, Y
Figure 14.19 Business cycle fluctuations around equilibrium unemployment.
1. Labour market equilibrium
The economy is initially at labour
market equilibrium at point A with
unemployment of 5%. The level of
aggregate demand must be as shown
by the aggregate demand curve
labelled ‘normal’.
2. A boom
Consider a rise in investment that shifts
the aggregate demand curve up to AD
(high), so that output and employment
rise. The economy is at B: with the
boom, unemployment falls below 5%.
The additional employment is called
cyclical employment.
3. A slump
If the aggregate demand curve shifts
down, then through the multiplier
process, output and employment fall to
C. Unemployment rises above 5%. The
additional unemployment is called
cyclical unemployment.
14.10 AGGREGATE DEMAND AND UNEMPLOYMENT
635
long run (model) The term does not refer to a period of time,
but instead to what is exogenous. A long-run cost curve, for
example, refers to costs when the firm can fully adjust all of the
inputs including its capital goods; but technology and the eco-
nomy’s institutions are exogenous. See also: technology,
institutions, short run (model), medium run (model).
• In Unit 15, the business cycle: We develop the model
in Figure 14.19 by asking what happens to wages
and prices in a boom and in a recession.
• In Unit 16, the long run: We use the wage-setting
curve and the price-setting curves to study the
long run, where output, employment, prices and
wages can change, as well as institutions and tech-
nologies. We ask how changes in basic institutions
and policies such as the weakening of trade unions, the increase in com-
petition in markets for goods and services, or new labour-saving
technologies will affect the aggregate economy.
The table in Figure 14.20 summarizes the different models we will use to
study the aggregate economy.
Unit Run What is
exogenous?
What is endogenous Problem to be addressed Appropriate
policies
Model to use
13,
14
Short Prices, wages,
capital stock,
technology,
institutions
Employment,
demand, output
Demand shifts affect unemployment Demand
side
Multiplier
14,
15
Medium Capital stock,
technology,
institutions
Employment,
demand, output,
prices, wages
Demand and supply shifts affect
unemployment, inflation and
equilibrium unemployment
Demand
side, supply
side
Labour market;
Phillips curve
16 Long Technology,
institutions
Employment,
demand, output,
prices, wages and
capital stock
Shifts in profit conditions and
changes in institutions affect
equilibrium unemployment and real
wages
Supply side Labour market
model with firm
entry and exit
Figure 14.20 Models to study the aggregate economy.
UNIT 14 UNEMPLOYMENT AND FISCAL POLICY
636
QUESTION 14.10 CHOOSE THE CORRECT ANSWER(S)
The following are the labour market and the multiplier diagrams,
representing the medium-run supply side and the short-run demand
side of the aggregate economy, respectively:
Employment, N
Wage-setting curve
Re
al
w
ag
e
Supply side (medium & long run)
Labour supply
Labour productivity
Price-setting curve
A
8.5
Output, Y
45º
Ag
gr
eg
at
e
de
m
an
d,
A
D
Demand side (short run)
AD (high)
AD (normal)
A
B
AD (low)
normal
boom
C
recession
Assume that the economy’s production function is given by Y = N,
where Y is the output and N is the employment. Based on this informa-
tion, which of the following statements is correct?
A rise in investment shifts the AD curve up, resulting in a higher
aggregate output. This causes the price-setting curve to shift up in
the short run, leading to higher employment.
A fall in autonomous consumption shifts the AD curve down,
resulting in a lower aggregate output. This causes the wage-setting
curve to shift to the left in the short run, leading to higher
unemployment.
Labour productivity shifts with the changes in aggregate demand in
the short run.
The shifts in the aggregate demand cause short-run cyclical
fluctuations in unemployment around the medium-run level shown
in the labour market diagram.
14.10 AGGREGATE DEMAND AND UNEMPLOYMENT
637
14.11 CONCLUSION
Economies often experience shocks to aggregate demand, such as a decline
in business investment or an increase in desired savings by households.
These shocks tend to be amplified by the process described by the multi-
plier. In addition to their first-round effects, there are second-round or
other indirect effects due to further declines in spending.
In the second half of the twentieth century, the advanced economies
enjoyed a great decline in economic instability, which was due in part to
larger governments and the existence of automatic stabilizers that
moderated swings in aggregate demand.
While active fiscal policy played its part, it had a mixed record. France
discovered in the early 1980s that a poorly planned fiscal expansion can
lead to a fiscal deficit with little benefit to the domestic economy.
In 2008, the world was reminded that even the rich countries can suffer
from economic crises, and the importance of fiscal policy in deep
recessions was reaffirmed. Unfortunately for the Eurozone, the hardest-hit
countries were unable to implement the necessary fiscal stimulus because
of fears of sovereign debt crises.
Concepts introduced in Unit 14
Before you move on, review these definitions:
• Multiplier process, multiplier model
• Marginal propensity to consume, marginal propensity to import
• Consumption function
• Investment function
• Goods market equilibrium
• Autonomous consumption, autonomous demand
• Target wealth
• Financial accelerator
• Automatic stabilizer
• Fiscal stimulus
• Paradox of thrift
• Government budget balance, deficit, surplus
• Primary deficit
• Government debt
• Sovereign debt crisis
• Positive and negative feedback
• Supply and demand sides of aggregate economy
• Business cycle fluctuations
• Long run, medium run, short run
14.12 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
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