UNEMPLOYMENT: Can Fiscal Policy Reduce the Rate of Unemployment?

To What Extent can Fiscal Policy be used to reduce the Rate of Unemployment?

Fiscal Policy. The budget. What exactly is it? By definition, fiscal policy involves the spending decisions and the taxation decisions of a government. Depending on how the government alters these factors, it can be used to reduce the rate of unemployment.

So how can fiscal policy decisions or changes in these decisions reduce the rate of unemployment?

Firstly, levels of unemployment can be reduced by increasing levels of government spending (G) which is a component of aggregate demand (AD). If a government say funded some new projects, then the availability and suitability of work becomes easier for people and so creates more jobs. As well, this can also lead to the multiplier effect because the change in AD would be likely to result in a greater final change in GDP.

Another way fiscal policy can reduce the rate of unemployment is by loosening/reducing tax boundaries namely income tax. This would increase the incentive to work because people would then retain more of their earned income, which would in turn increase levels of consumption and so raise levels of aggregate demand (AD). Lower taxes is also likely to stimulate more investment from firms which then generates more opportunities to lower the rate of unemployment.

However, as always in economics there are always constraints to its theory when it is applied to a wider economic context. So, it goes without saying that there are constraints to these policies. For example, the UK’s budget deficit is currently very high in comparison to its ideal figure of 3% of GDP. This leaves the government borrowing money from other countries, more than it can afford in fact - which has led to a budget deficit of 80+ %. In this case, the use of an expansionary fiscal policy would add more to the national debt (the summation of all deficits over time). 

Moreover, high levels of government borrowing is likely to influence monetary policy factors as it would, in theory, push up the rate of interest because the government has to persuade the money markets to ‘buy’ their debt. These higher rates of interest contribute to low levels of investment in the private sector by increasing the cost of investment which in turn makes saving more attractive.

When evaluating these theories it is important to understand that the extent to which fiscal policy can be used to reduce the rate of unemployment depends on key variable factors. An extremely key factor in determining how much of an effect fiscal policy can cause is the type of unemployment. For example, it would be easier to correct cyclical unemployment by adjusting tax and government spending decisions than it would be to correct structural unemployment. Furthermore, the length of unemployment is key in evaluating its effectiveness. The longer that people are unemployed, the harder it comes to re-employ them (this is due to concept of immobility of labour/flexibility).

Another key factor in assessing the possible outcome of using fiscal policy to reduce the rate of unemployment is the size of the multiplier which of course, is dependent on the size of the initial injection.

So to actually answer the question at hand, fiscal policy can and should be used to reduce levels of unemployment. However, it should be duly noted that the extent to which it can be effective relies on several key variables. 

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

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