1. Renowned economist Arthur Melvin Okun showed the pattern that the unemployment rate and GDP at full employment conditions have a direct relationship between each other. Yet, he believes, the higher unemployment rate, the bigger amount of real GDP is behind of the amount provided at full employment. Its essence of the law is that if the actual unemployment rate exceeds the natural 1%, the real GDP lags at 2.5% (Ball, Jalles & Loungani, 2014). This ratio is called Okun's law. For instance, if the actual unemployment rate in some country is 18.3%, which is more than the natural rate for 10.5%, and GDP is $65000 million, then the lag of real GDP from the one under conditions of full employment is $17062.5 million (10,5*2,5 = 26,25%; 65 000*26,25/100 = $17062,5 million) (Ball, Jalles & Prakash, 2014). That is, if the economy has created jobs for all working-age population, the volume of goods and services production would be $82062.5 million.
2. Therefore, in our particular situation, the normal rate of growth of GDP is 3% and the current unemployment rate is 6%, an increase in GDP growth to 4% would decrease the unemployment rate for 0.25% according to Okun’s law.
The business cycle - is the periodic rise or decline in real GDP at the background of the general trend to increase. Reasons for cyclical nature of business are:
• political and just random events;
• changes in the monetary policy (fluctuations in the money supply);
• lack of domestic investment;
• changes in the prices of oil, gas and other raw materials etc.
Cycles of business activity:
Hence, when total output, income, employment, and trade decline for 6 to 12 months, the economy is now at recessional business cycle.
3. Aggregate demand (AND) - a total amount of domestic goods and services that households are willing to buy, along with companies and government and economic agents of other countries at a certain level of domestic prices.
If government expenditures on goods and services increases, the aggregate demand also raises up due to the additional demand from the government and the subsequent expansion of income and expenditure in the private sector. To increase this spending, government typically borrows money, creating additional demand for funds. Interest rates are rising up because of this and reduce private sector investment. Overall, due to multiplier expansion of private consumption expenditure, the aggregate demand increases by increasing the public spending.
The tax reduction increases used household income, which is aimed at consumption and savings. Aggregate demand expands by the reduced government expenditures and increased private consumption.
In this respect, the raise of government expenditure would definitely increase the aggregate demand more significantly rather than the equal sized decrease in taxes.
4. The contractionary fiscal policy is based on cutting government expenditures and raising the taxes. This type of fiscal policy is mostly used to combat the recession gaps. The government costs reduction will subsequently reduce the aggregate demand. The same result can be achieved by increasing taxes.
Anti-cyclical fiscal policy is to promote economic development in the direction, opposite to where the forces of cyclical development are pushing the economy. This type of policy stimulates the demand during the recession and limits it during the economic recovery. This means that the government must provide a planned budget deficit when the economy threatens recession or budget surplus during economic recovery periods. This countercyclical fiscal policy should maintain an adequate level of aggregate demand to ensure full employment.
However, deficits and surpluses arising because of the expansionary, contractionary or counter-cyclical fiscal policy can have different effects. Moreover, these consequences can affect a significant restructuring of the Keynesian model when, the fundamental objective of fiscal policy is to eliminate unemployment and inflation.
5.
Increasing income tax – contractionary;
Bailing out the auto industry – expansionary;
The purchase of military helicopters – expansionary.
Reference
Ball, L., Jalles, J., & Loungani, P. (2014). Do Forecasters Believe in Okun’s Law? An Assessment of Unemployment and Output Forecasts (p. 5). n.p.: International Monetary Fund.
