Question #2494

During a recession, the government can always restore full employment if it uses expansionary fiscal policy to restore trend real GDP growth.

True
False

Answer #12429

Answer: False

Explanation

The answer is False.

To see why, we might usefully construct a scenario that will explicate the options available to a government:

Trend real GDP growth rate is 3 per cent annum.

Labour productivity growth (that is, growth in real output per person employed) is growing at 2 per cent per annum. So as this grows less employment in required per unit of output.

The labour force is growing by 1.5 per cent per annum. Growth in the labour force adds to the employment that has to be generated for unemployment to stay constant (or fall).

The average working week is constant in hours. So firms are not making hours adjustments up or down with their existing workforce. Hours adjustments alter the relationship between real GDP growth and persons employed.

We can use this scenario to explore the different outcomes.

The trend rate of real GDP growth doesn't relate to the labour market in any direct way. The late Arthur Okun is famous (among other things) for estimating the relationship that links the percentage deviation in real GDP growth from potential to the percentage change in the unemployment rate - the so-called Okun's Law.

The algebra underlying this law can be manipulated to estimate the evolution of the unemployment rate based on real output forecasts.

From Okun, we can relate the major output and labour force aggregates to form expectations about changes in the aggregate unemployment rate based on output growth rates. A series of accounting identities underpins Okun's Law and helps us, in part, to understand why unemployment rates have risen.

The rule of thumb that Okun came up with was that if the unemployment rate is to remain constant, the rate of real output growth must equal the rate of growth in the labour force plus the growth rate in labour productivity, assuming no change in working hours per week.

It is an approximate relationship because cyclical movements in labour productivity (changes in hoarding) and the labour force participation rates can modify the relationships in the short-run. But it provides reasonable estimates of what happens when real output changes.

The sum of labour force and productivity growth rates is referred to as the required real GDP growth rate - required to keep the unemployment rate constant.

Remember that labour productivity growth (real GDP per person employed) reduces the need for labour for a given real GDP growth rate while labour force growth adds workers that have to be accommodated for by the real GDP growth (for a given productivity growth rate).

So in the example, the required real GDP growth rate is 3.5 per cent per annum and if policy only aspires to keep real GDP growth at its trend growth rate of 3 per cent annum, then the output gap that emerges is 0.5 per cent per annum.

The unemployment rate will rise by this much (give or take) and reflects the fact that real output growth is not strong enough to both absorb the new entrants into the labour market and offset the employment losses arising from labour productivity growth.

So the appropriate fiscal strategy does not relate to "trend output" but to the required real GDP growth rate given labour force and productivity growth.

The two growth rates might be consistent but then they need not be. That lack of concordance makes the proposition false.

The following blog post may be of further interest to you:

What do the IMF growth projections mean?

That is enough for today!