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By Karl Smith

Ryan Avent writes

A common argument at this point in the discussion is that the Fed is recusing itself from the business of macroeconomic stabilisation and fiscal policy should therefore be used to bring down unemployment. The inflation constraint prevents this, however.

The realization that the Fed moves last is important and I am confident that this is what Ryan is getting at.

However, in the interest of deep understanding its important to point that this is not – in fact – true.

There is – practically at least, possibility theoretically – no limit on the ability of the fiscal authorities to bring down unemployment regardless of the Fed’s inflation target.

The easiest way to do this would be to raise taxes on current workers and use the money to hire other workers. First order response of this policy be lower the after tax real wage.

You simply continue this process until the after tax real wage is reduced to a level consistent with full employment at the current level of nominal expenditures.

You face two second order responses, one that will tend to increase unemployment, the other to lower it.

The first, is this: If government workers are less productive than private workers. And, if enough private workers are drawn out of private employment into government employment then total output can fall. This means that the current level of nominal expenditures would tend to produce inflation and the Fed must contract nominal expenditures. This will cause more private sector workers to become unemployed and counteract your effect.

However, so long as the productivity of government workers is not sufficiently negative then this is self-limiting. As the number of private employs falls, the marginal product of private labor will rise. This will offset the total productivity loss and unemployment will still fall.

The second, is that as long as effective labor elasticity is not negative a decline in the real wage will cause labor supply to fall. Falls in labor supply mechanically reduce the unemployment rate.

Source: Inflation And Fiscal Policy