Q. What is “full employment”?

A. Full employment doesn’t mean that everybody has a job. It doesn’t even mean that everyone in the labor force has a job. In fact, it’s not possible for everyone in the labor force to have a job because 1. some folks are always between jobs (frictional unemployment) and 2. some folks are live in depressed areas with declining industries and require time to move away and find work (structural unemployment). What full employment does mean is an “acceptable” level of unemployment. What is acceptable varies over time. We like to get as close to zero unemployment as possible, but as we approach that goal, inflation will start to accelerate. The amount of inflation we get as we approach zero unemployment depends upon how much inflation we’ve been experiencing, and for how long. Back in the late 1970’s, we’d been having high levels of inflation for several years. Because of this, there was quite a bit of inflation associated with fairly high levels of unemployment. Back then, 7.5% unemployment might have been considered “full employment) because that unemployment level might also be associated with 7-8% annual inflation. These days, 7-8% annual inflation is unthinkable. It also isn’t likely to happen unless we get really close to zero unemployment. Now days, full employment is probably about 3.5-4% unemployment.

 

Q. What is inflation?

A. Inflation is an increase in the general price level. The traditional explanation for inflation is “too much money chasing too few goods”. In other words, we’re attempting to purchase more goods and services than the economy can produce, so we find ourselves “bidding” against one another for these increasingly sought after goods, driving their prices up. This is called “demand-pull” inflation. Note that demand-pull inflation presumes that the economy is producing at it maximum rate (at capacity, or at full employment). Another kind of inflation is called “cost push” inflation. Cost push results from an increase in the cost of inputs, such as labor, to the productive process. Costs go up, so prices go up. Demand-pull inflation can lead to cost push, too. As people bid up the price of goods via demand-pull, their wages will tend to be bid up as employers struggle to increase output to meet the vibrant level of demand.

As people continue to experience inflation, they begin to change their behavior in ways that help protect them from inflation’s effects. People tend to look for “cost of living” adjustments to be built into their labor contracts or employment agreements. Businesses tend to build inflation adjustments into contracts and goods prices. People hold onto less money, and tend to buy things “before the price goes up”. All of these behaviors tend to encourage more inflation. As a result, a certain level of inflation becomes “expected”, and tends, therefore, to actually occur. This inflation is called “embedded” inflation. It takes quite an economic downturn before this embedded inflation rate is reduced or eliminated altogether. The recession of 1980 had the effect of eliminating the embedded inflation that was established in the 1970’s.

To Read more about inflation and the Consumper Price Index (CPI), Click Here

 

Q. What is the multiplier?

A. The multiplier is simply the ratio of the increase in GDP to the initial increase in expenditure that caused the increase. If expenditure is increased, say an increase in the flow of government deficit spending, an increase in GDP will result which is several times larger than (a multiple of) the original expenditure increase. There are at least two ways of explaining this. The first has to do with the level of savings, the second deals with the level of expenditures.

 

We have discussed, elsewhere, the fact that GDP is stable, or at equilibrium, when Savings equals Investment (S=I). The more complete expression of this equilibrium condition is Savings plus Taxes equals Investment plus Government spending (S + T) = (I + G). If we start in an equilibrium condition where S + T = I + G, and then G goes up, then S+T must now be less than I + G. Since S and T are “leakages” to the income flow, and I and G are “additions” to the flow, it follows that we now have more additions to the consumption stream than we have leakages, and the rate of consumption and GDP will now increase. This increase will continue so long as S + T < I + G. We know, however, that as GDP rises, so does S. Therefore, eventually, S will increase to the point where (S+T) = (I+G) once again. When this happens, we’ll be at a new equilibrium, and GDP will stop increasing. The critical question, then, is “by how much does GDP need to increase to create enough additional savings to offset the increase in G. If savings were to increase by, say, 20 cents for every dollar increase in GDP, then we would need a 1/0.2 or 5 dollar increase in GDP to get an additional dollar in savings. So, every dollar increase in G will cause a $5 increase in GDP in order to generate the $1 additional saving necessary to offset it. This is the multiplier. The expenditure multiplier can always be calculated by dividing the amount by which savings increases with an increase in GDP into one. The amount by which savings increases with in increase in income (or GDP) is called the Marginal Propensity to Save (MPS). The expenditure multiplier, therefore, is equal to 1/MPS.

There is also a tax multiplier, which is smaller. The tax multiplier is smaller because of the difference in the first round of consumption. When the government increases deficit spending, for example, the first round of consumption is the government spending itself. The government has bought something, thus directly creating additional demand equal to the expenditure. When the government gives a tax cut, however, the increase in consumption is only the mount by which folks actually increase their spending in response to the tax cut. The amount by which people actually increase their consumption in response to an increase in their income is called the Marginal Propensity to Consume (MPC). Since we either save or spend an additional dollar of income, the MPC and the MPS sum to one. (i.e. if you spend 80 cents of and additional dollar’s income, you must be savings 20 cents). So, when the government gives a tax cut, spending actually goes up by the MPC times the increase (say 80% of the increase, not by the whole amount). Since the first round increase in spending is less than the increase in spending that occurs when the government increases deficit spending, the resulting increase in GDP is smaller, too. The tax multiplier is always one less than the expenditure multiplier.

Finally, we have the balanced budget multiplier. If government spending increases by X dollars, and taxes are increased by the same X dollars to fund the spending, the balanced budget multiplier is the factor by which GDP will increase. Let’s say that the expenditure multiplier is 5. That means the tax multiplier equals one less or 4. As a result of the X dollar increase in G, income will go up by 5 times X. However, since taxes have been increased by X dollars to finance G, this will cause a simultaneous decrease in GDP. GDP will tend to contract by 4 times X. When we set the increase against the decrease up by 5X, down by 4X, the result is an increase in GDP of 1X. Hence, the balanced budget multiplier is always equal to 1.

The second way of looking at the multiplier is from the consumption side. When spending goes up, say in increase in government deficit spending of X dollars, we get the following pattern of consumption. The government spending increases GDP by X dollars, and since those dollars are being spent on goods and services, this means the peoples incomes go up by X dollars. With the increase in income of X, people will increase their spending by the MPC times X. This second round of spending becomes income for those who receive it, thus we have a secondary increase in income of the MPC(X). Those receiving this increase in income will increase their spending by the MPC times it. So we have a third round spending increase of MPC(MPC)(X) or MPC²(x). This spending becomes income for others who increase their consumption for a fourth round of spending, and on and on until there is sufficient additional savings flow generated to offset the initial increase in spending. It all looks like this:

 

 

 

Gov. Spending $X becomes income equal to $X leads to

Second round spending MPC(X) becomee income equal to MPC(X) leads to

Third round spending MPC²(X) becomes income equal to MPC²(X) leads to

Fourth round spending MPC³(X) becomes income equal to MPC³(X) leads to

Fifth round spending MPC⁴(X) becomes income equal to MPC³(X) leads to

And on

And on

And on

Nth round spending MPC^n-1(X) which is a very small number

Effectively zero

 

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Total change equal 1/(1-MPC)(X) . 1/(1-MPC) is the expenditure multiplier looked at from the expenditure side. Since 1-MPC equals the MPS, this is also equivalent to 1/MPS which is the definition of the expenditure multiplier given above.