Question: To what degree can fiscal policy be used to increase employment?
Fiscal policy is the manipulation of government expenditure (G) and taxation (T) by the government to influence macroeconomic variables.
An expansionary fiscal policy means G > T so AD rises. Multiplier effects make AD rise further. AD shifts right so the price level rises, real GDP rises & employment increases.
Fiscal Policy influences AD through various mechanisms. For example, a rise in government spending means there is more spending in the economy so AD and employment increases. Moreover, a fall in income tax means consumers’ real disposable income rises so consumption rises and employment rises. Also, a fall in corporation tax means firms’ after-tax profits increase, so the profitability of investment rises, investment rises and AD rises.
The effectiveness of fiscal policy to boost employment depends on many factors.
Firstly, fiscal policy is more effective in raising AD and employment the larger the rise in G and/or the larger the fall in T. A large rise in G and/or a large fall in T means AD rises a lot and shifts rightwards, the price level rises, real GDP rises and employment rises.
Moreover, fiscal policy is more effective in raising AD, real GDP and employment the more elastic is LRAS. If LRAS is elastic there is a lot of spare capacity, an expansionary fiscal policy boosts AD, real GDP rises a lot, employment rises a lot but the price level rises a little bit (or maybe stays the same).
Lastly, the effectiveness of fiscal policy depends on the level of government debt. The government cannot keep running a fiscal deficit because the government will build up debt that could become unsustainable. A level of debt too high means creditors will begin to fear that the government will default on its debt so creditors will charge the government a higher rate of interest. A higher interest rate means the government’s debt rises, the risk of default rises, credit worthiness falls, creditors charge the government higher interest rates and the spiral continues. Eventually the government must decrease government spending and increase taxation to repay the debt. AD will fall, real GDP falls and the economy falls into a recession.