The Role of the Government and

1
TOPIC 4

• The Role of the Government and
• Fiscal Policy

2

• The I-S Curve and Fiscal Policy

3
Some Equations From Lecture 1

• The demand side of the economy
• Y C I G NX
• Given the demand side of the economy and
  definitions for disposable income and government
  deficits, we have
• S(hh) S(govt) I NX
• S I NX
• The fourth curve in our class is the IS curve.
  The IS curve is so named because it documents the
  relationship between saving and investment on
  the demand side of the economy (holding NX
  constant).

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The IS Curve

• The IS curve is the representation of the demand
  side of the economy drawn in Y,r space.
• Highlights the relationship between interest
  rates and aggregate expenditure (Y).
• Interest rates affect demand through its affect
  on investment (I).
• Key equation
• Y C(.) I(.) dIr G NX
• Remember I I(.) dI r (given our
  linearization assumption in Topic 3)
• Remember C C(.) (given our discussion
  in Topic 3)

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Fourth Major Curve of the Course IS curve

• C(.) is a function of PVLR (Y, Yf, W), tax
  policy, expectations (i.e., consumer
  confidence), liquidity constraints.
  (Consumption can be endogenous in model)
• I(.) is a function of A, business confidence,
  liquidity constraints, uncertainty, and
  investment tax policy. (Total investment is
  endogenous to our model)
• G is a function of government policy (we will
  discuss this shortly). (G is exogenous in our
  model.)
• NX will be set to zero until Topic 8.
• The IS curve relates Y to r. How do interest
  rates affect Y?
• As r falls, Investment increases (due to MPK and
  firm profit maximization behavior).
• IS curve is downward sloping in r, Y space.

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Demand Side Analysis (IS Curve)

r
r
r
IS
Y
Y
Suppose r is set by the Fed at the level of r
(we will explore this in depth later in the
course). For a given r, we can solve for the
level of output desired by the demand side of the
economy. Ignore the supply side of the economy
for awhile. Will return to it in Topic 6.
Note Y need not equal Y - I drew it this way
for illustrative purposes.
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Some Thoughts on IS Curve

• What shifts the IS curve?
• Anything that causes C(.), I(.) or G to change
  (or NX when we model it).
• What shifts IS curve to the right? (i.e., makes Y
  higher on the demand side of the economy)
• Increase in consumer confidence (expectations of
  future PVLR)
• Permanent increase in stock market wealth.
• A permanent reduction in income taxes (if
  households are PIH or Keynesean)
• A temporary reduction in income taxes (if
  households are Keynesean or Liquidity Constrained
  PIH).
• An expected future increase in TFP (stimulates
  investment demand).
• An increase in government spending (i.e., war).
• Changes in r WILL NOT cause IS curve to shift
  (causes movement along IS curve).

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Suppose Consumer Confidence Falls

• Suppose consumer confidence falls (and no effect
  on Y). IS curve will shift in.

r
C(.) falls
r
r
IS1
IS
Y
Y
Y1
Assume that I(.), NX, and G do not change (all
else is equal)
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Fiscal Policy

• Fiscal policy is the use of government spending
  (G), taxes (tn, tc) and transfers (Tr) to
  stabilize the economy.
• Governments can have
• o Output targets
• o Price targets
• o Unemployment targets
• Stabilizing the economy means moving the economy
  towards its targets. We will ignore price
  targets for now (we have no prices in our model
  yet).
• Suppose the government has an output target and
  suppose that target is Y (we will also explain
  why Y is a good target later in the course).
• Fiscal policy then would be the manipulation of
  G, taxes and transfers to move the economy
  towards Y. (Assumes government knows where Y
  is - we will discuss other drawbacks to fiscal
  policy later in the course).

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Example of Fiscal Policy Consumer Confidence
Falls

• Government can undo the decline in consumer
  confidence by increasing G or decreasing tn -
  this is fiscal policy

r
C(.) falls
r
r
G increases
IS1
IS IS2
Y
Y
Y1
Compute Change in G If ?G -?C(.),
Y will remain
unchanged (taking r as fixed)
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• A Look at U.S. Debt and Deficits

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U.S. Federal Deficit (Relative to GDP)
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U.S. Federal Deficit (Relative to GDP)
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U.S. Public Debt (Relative to GDP)
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U.S. Public Interest Paid (Relative to GDP)
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Who Owns U.S. DEbt?
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• The Cyclicality of Government Budget Deficits

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Some Additional Structure on Taxes and Transfers

• Let us start with some definitions about debts
  and deficits.
• Tax Revenues tnY (where tn is the
  marginal tax rate on income)
• Transfers Payments Tr g Y (where g
  proxies for how transfers go up when
  aggregate income falls i.e., welfare
  transfers are higher in recessions)
• Rationale for specifications
• When Y increases, tax revenues increase (more
  earnings in economy).
• - This is built into the tax code.
• - You are taxed based upon what you earn.
• When Y increases, transfers payments fall (less
  people on welfare)
• - This is built into our social programs.
• - We transfer more money to people when their
  income is low.

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Some Deficit Terminology

• Actual Government Deficits
• Outlays (G and Tr) Revenues (T)
• G Tr g Y - tnY G Tr (g tn)Y
• Note For now, ignore other government revenues
  and expenses (like interest on government debt).
  See text for further discussion if interested.
• Definition Structural Budget Deficit is the
  deficit that would exist if the economy were
  at Y
• Structural Budget Deficit G Tr (tn
  g)Y
• Note Difference between structural deficits and
  actual deficits is only due to differences
  between Y and Y.
• Cyclical Budget Deficits Actual Budget
  Deficits - Structural Budget Deficits.
• Cyclical deficits occur anytime Y does not equal
  Y!

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The Nature of Deficits

• Deficits are countercyclical! (They rise when Y
  falls and fall when Y rises)
• Even if the government has a policy (combination
  of G and T) that would lead to no deficits at Y
  (the target level of output for the economy),
  deficits could still occur.
• The reason Y does not always equal Y.
• Why do we get countercyclical deficits?
• Welfare Payments, Unemployment Insurance, and
  Tax System dampen the effects of consumption over
  the business cycle.
• T goes up when times are good (like in the late
  1990s).
• G/Tr goes up when times are bad (welfare
  payments).
• We refer to such policies that dampen consumption
  as automatic stabilizers
• Given automatic stabilizers (and potentially
  proactive governmental fiscal policies), cyclical
  deficits seem to be an inherent part of our
  economy.

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Should Governments Try To Prevent Deficits?

• Examples U.S. Balanced Budget Amendment.
  Maastricht criteria for entry to European
  Economic and Monetary Union (EMU) that
  deficit/GDP be 3 or less and that debt/GDP be
  60 or less.
• Benefits Limit Spending If spend today,
  government must
• 1) Raise Taxes Now (changing taxes
  frequently creates economic uncertainty)
• 2) Raise Taxes in Future (higher taxes cause
  disproportionately more distortions )
• 3) Print Money In Future (could lead to
  inflation)
• Is there a cost? Yes - balanced budget
  amendments can make economic situations worse.
  Refer back to the example earlier in this lecture
  when consumer confidence fell.
• As Y fell, tax revenues fell. As tax revenues
  fell, deficits (cyclical) increased. If the
  government had to balance the budget, they would
  either have to cut G or increase T - both of
  which would cause the IS curve to shift further
  to the left.
• Conclusion - it may be bad to have policies
  requiring governments to eliminate all deficits,
  but there may be some benefits from eliminating
  structural deficits.

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• Government Spending at Y (model preview)

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Revisiting Potential Output (Y)

• Potential output is the level of output in the
  economy when the labor market clears
• Formally Y A K1-a (N)a
• Where we are heading
• o Short run period of time when the labor
  market does not clear
• o Long run period of time when the labor
  market clears (given A, K and other inputs).
• From topic 2, market clearing N depends on
• o Labor Supply PVLR, taxes, population, value
  of leisure
• o Labor Demand A and K (and eventually other
  inputs like oil prices)

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Increase in G at Y Investment Adjusts
LRAS Y Yf(A,K,N)
r1
r
IS YCIG
Y
Y
Suppose we start at Y such that Y is pinned down
by the supply side (i.e., labor markets clear,
all resources used efficiently)
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Increase in G at Y Investment Adjusts
LRAS Y Yf(A,K,N)

r1
I
r
G
IS1 CI1 G1
IS YCIG
Y
Y
Assumption Assume increase in G has no effect on
A (for now) Model Increase in G has no effect
on N (no effect on labor supply or labor
demand (holding A fixed)). So, no effect on Y.
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What is the Effect of Running a Deficit at Y?

• Situation 1 Crowding Out of Investment
• Equation 1 Y C I G Equation 2 SHH
  Sgvt I (if NX 0)
• If Y is pinned down by supply side of economy
  (such that ?Y 0 if G increases), then either C
  or I must fall to offset increase in G (i.e., ?G
  - ?I).
• Why would I fall? Increase in interest rates
  (we will prove once we build a model of money
  market).
• What is the effect of falling I (due to
  increased G) on future generations? Lower I
  today, means lower K tomorrow. Lower K tomorrow
  means lower Y tomorrow (lower economic growth).
• If at Y, increase in deficit will hurt future
  generations unless the deficit has a non-trivial
  effect on A (given Cobb Douglas Production If
  ?A gt 0.3 ? K, then deficit could help
  future generations.)

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What is the Effect of Running a Deficit at Y?

• Situation 2 Ricardian Equivalence
• Adjustment occurs on C as opposed to I (to keep Y
  at Y)
• Definition Ricardian Equivalence Theory that
  states that consumers behavior is equivalent
  regardless of whether the government finances G
  (govt. expenditures) through increased taxes
  or through increased debt
• Key If the government floats debt to finance
  the spending today, consumers realize that the
  government, at some time in the future, will have
  to raise taxes to pay back the debt.
• Summary A reduction in taxes today (or an
  increase in G today) will be seen as being
  accompanied by higher taxes in the future.
  Households will save today to fund the future
  tax increases (they expect disposable income in
  the future to fall). National Saving would
  remain unchanged.
• In terms of equations Y is fixed, C falls and
  Shh goes up (prevents crowding out of
  investment I can stay fixed)

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Does Ricardian Equivalence Hold?

• For the most part, there is little evidence to
  support the existence of Ricardian Equivalence.
• Why? Myopia
• Liquidity Constraints
• High Levels of Impatience
• Do not care about bequests/future generations
• Timing of Taxes is Important (taxes are not
  lump sum)
• Even if taxes go up in the future, only adjust
  savings by small amounts each period.
• For the rest of the course, we will assume
  consumers are non Ricardian unless told
  otherwise. This means that consumers will not
  adjust their consumption downward today in
  expectation of an increase in taxes tomorrow.
• Ricardian consumers, however, would adjust their
  consumption downward today in expectation of
  increases in taxes tomorrow (because PVLR falls)
  in response to a permanent increase in G.

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Summary Effects of Deficit Financed Government
Spending at Y

• Benefits
• o Can potentially increase future growth if it
  increases future TFP (think infrastructure
  spending).
• Costs
• o Crowds out private investment (which hurts
  future generations)
• o Have to pay distortionary future taxes
  (which hurts future generations)
• o Government spending is often inefficient
  (which wastes resources)
• Caveats
• o There is another margin of adjustment in an
  open economy borrow from the world. Hurts
  future generations because some future income
  will flow out of the country to repay the debt.
• o Equity issues within current generation may be
  important but those are separate from
  deficit issues. Deficits focus on equity across
  generations.

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• Government Spending During Recessions

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Summary Effects of Deficit Financed Government
Spending During Recessions

• Benefits
• o Can potentially increase future growth if it
  increases future TFP (think infrastructure
  spending).
• o Can utilize slack resources in the economy
  If economy is below potential, government
  spending can generate more output.
• Costs
• o Crowds out private investment (which hurts
  future generations)
• o Have to pay distortionary future taxes
  (which hurts future generations)
• o Government spending is often inefficient
  (which wastes resources)
• Note
• o Other costs and benefits are the same as
  increasing G at Y

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Government Spending Multiplier

• Tries to measure the net change in GDP today from
  a given change in government spending today.
• Measured by ?Y/ ?G
• By construction, only includes current GDP
• o Mobilizing slack resources
• o Crowding out of investment
• Ignores potential future costs
• o Does not include potential effects on future
  productivity
• o Does not include effect of potential
  distortionary tax increase in future
• Ignores that slack resources also have value
• o Slack workers value leisure and slack machines
  forgo depreciation.

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How Big Can the Multiplier Be?

• In the long run (when Y Y), the multiplier is
  zero
• o Interest rates adjust and crowds out
  investment
• o Output is pinned down by the supply side of
  the economy
• When economy is below Y (recession), the
  multiplier can be significant
• o Slack resources are mobilized
• o Interest rate effect is smaller such that
  investment is not perfectly crowded out.
• o Output determined in part by demand side
  of the economy.
• This simple model underlies the old Keynesian
  intuition often seen in the popular press
  advocating increased government spending during
  recessions.

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A Simple Model of a Government Spending Multiplier

• Focus on demand side only (no link to supply
  side)
• Assume interest rates do not adjust to change in
  government spending
• o A crazy assumption (we will model interest
  rates next week).
• o Not so crazy when interest rates are stuck
  at zero (what economists call the Zero Lower
  Bound).
• o Ignoring interest rate changes assumes away
  the crowding out of investment.
• Assume consumers do not adjust spending to
  changes in government spending.
• o Implies consumers are not Ricardian.

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Why is There a Potential multiplier When Y lt Y?

• Suppose we have the following model
• C a b(Y T) ltlt assume some fraction
  of consumers are liquidity constrained
  so they act Keynesiangtgt
• I I0 I1 r ltltInvestment is negatively
  related to interest ratesgtgt
• T tn Y ltltMarginal tax rate on labor
  incomegtgt
• Other assumptions
• Transfers 0 G G0 Y ltlt Y
  closed economy (NX 0 always)
• What is the equilibrium level of Y?
• Y C I G a b(Y tnY) I0 I1 r G0
  
• Solve for Y (Use algebra one equation, one
  unknown)
• Y a I0 I1 r G0 / 1-b(1-tn)

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What is the private sector multiplier in the
Simple Model?

• Given the Simple Economy on Previous Page
• Y a I0 I1 r G0 / 1-b(1-tn)
• What is the multiplier of a change in government
  spending (G) on Y?
• dY/dG 1/1-b(1-tn)
• What is b? Some estimates range from 0.3-0.4 in
  recession.
• Where are the estimates from? -- Micro data
  analyzing tax rebates (a change in taxes not a
  change in government spending).
• What is t? Marginal tax rate roughly 0.25-0.35
• What is the government spending multiplier in
  this simple model?
• dY/dG is approximately 1.3 (if b 0.35,
  t0.3)

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The Simple Keynesian Multiplier

• Upper bound on the true (or net) government
  spending effect on output.
• o Ignores the crowding out of investment by
  holding interest rates fixed.
• o Ignores consumer responses by imposing
  Ricardian equivalence.
• o Ignores any supply side effects (prices may
  adjust more on that when we build a model of
  prices).
• Government spending multipliers will be higher in
  recessions
• o More slack resources can be mobilized without
  crowding out investment.

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Estimated Government Policy Multipliers in the
Data

• Typically estimated by looking at correlation
  between G and Y in time series data.
• o Difficult because government mainly tries to
  stimulate economy in recessions (build in
  negative correlation)
• o However, need to focus on government spending
  in recessions because multipliers are
  different when YY and Y lt Y.
• o Hard to do proper counterfactuals
• Two famous papers using wars as instrument
• o Christy Romer 1.6 Robert Barro 0.6.
• Some recent studies look at state-level spending
• o Large multipliers 1.5 - 2.0
• o But, by construction, no interest rate
  response (no crowding out)

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My Thoughts

• In the long run, multiplier close to zero
• o Output determined by supply side of the
  economy
• o Most government spending does not increase TFP
• In recessions, multiplier positive but likely
  small
• o Output determined by demand side of economy
  (utilizes idle resources)
• o But typically interest rates adjust, so
  investment partially crowded out.
• o Also, inefficiencies likely to be huge how
  do you spend 800 billion quickly and
  efficiently.
• Often a mismatch between slack resource effect
  and increasing TFP effect
• o Lots of slack resources in Detroit. Do we
  need more roads in Detroit?

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Tax Cuts During Recessions

• Another way to stimulate the economy during
  recession is cut taxes
• o Consumption labor income taxes, consumption
  taxes
• o Investment corporate income taxes,
  investment tax credits
• Common view is that tax cuts are less effective
  at stimulating GDP (for a given 1 increase in
  deficit)
• o Lower bang for buck
• o Do not get direct effect of government
  spending
• Recent research says they can be effective
• o Tax rebates to households (C)
• o Firms are very responsive to bonus
  depreciation allowance (I)
• Different efficiency trade-offs (less wasteful,
  no direct effect on TFP)

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• Definition Supply Side Economics

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Supply Side Economics

• Any fiscal policy designed to stimulate the
  supply side of the economy (A, K and N)
• Examples
• 1) Changing marginal tax rates (stimulate N)
• As discussed before , these policies may not
  have big effects (off setting income effects and
  substitutions effects empirically small
  estimates of labor supply response).
• 2) Subsidizing A and K (investment tax credits,
  research and development subsidies, subsidizing
  education, etc.)
• These programs have been shown as being
  effective ways to promote economic growth within
  an economy.

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• A Discussion of Inequality

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Inequality Mania

• Recent empirical work showing inequality is
  increasing
• o Income inequality (Kevin Murphy, Larry Katz,
  Emmanuel Saez, Thomas Piketty, Ed Glaeser).
• o Consumption Inequality (Steve Davis , Me)
• o Employment Inequality (Kevin Murphy, Bob
  Topel, Me)
• o Wealth Inequality (Thomas Piketty, Emmanuel
  Saez)
• What are the causes of increased inequality?
• Is increased inequality detrimental to a society?

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Thomas Piketty Capital in the Twenty First Century

• Book Capital in the Twenty First Century -
  Worldwide best seller.
• Documents wealth inequality increases around the
  developed world.
• Claim economic conditions are such that
  eventually most wealth will be concentrated in
  the hands of the rich.
• o Forces will continue to make inequality grow.
• o Reason rate of return on capital gt income
  growth (i.e., r gt g)
• Policy prescription Tax wealth
• What we will do Walk through the Piketty
  argument and discuss necessary assumptions (and
  plausibility of assumptions). Draw on discussion
  by Justin Wolfers (http//users.nber.org/jwolfers
  /papers/Comments/Piketty.pdf)

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U.S. Income Inequality Top 10 Kuznets Curve
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Cross-Country Income Inequality Top 1
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U.S. Wealth Inequality
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Some Key Ingredients for the Piketty Story to hold

• An identity Define ?t as the capital share of
  total income in year t. By definition, that is
• This is not controversial. By definition
• Note Under a Cobb-Douglas production function,
  ?t 1-a is fixed over time (at some number like
  0.3).
• Note rt is an average return across different
  types of capital.

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Some Key Ingredients (in bold) for the Piketty
Story to hold

• Start with our identity and assume interest rates
  are constant over time
• Assume there is no depreciation of the capital
  stock such that ?Kt It
• Assume saving is a constant fraction of income
  (remember S I)

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Some Algebra.(and one more assumption)

• Assume Y grows at a constant rate g

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Pikettys Argument

• Piketty argues that g will fall going forward due
  to technological progress slowing down or aging
  of population.
• Since r and s are assumed fixed, this will
  increase the capital share going forward
• Since rich own capital, this will increase share
  of total income accruing to the rich
• o Concludes increasing inequality as a
  fundamental law of capitalism

53
Three Key Ingredients of Pikettys Argument

• Interest rates are constant over time
• o In our model, interest rates equal MPK
• o As capital increases, MPK falls, so interest
  rates fall (lower capital share)

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Three Key Ingredients of Pikettys Argument

• No depreciation of capital stock
• o Capital stock depreciates over time
• o Correct formula with depreciation
• o Implies capital share rises more slowly as g
  decreases (more capital investment is needed
  to replace depreciated capital)

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Three Key Ingredients of Pikettys Argument

• National saving is a constant fraction of income
• o Savings not constant
• o According to PIH, as PLVR of rich increases
  going forward, savings rate will decrease
  (consume more today).
• o Rich will eat some of their extra anticipated
  future income.

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Some Other Issues

• Most of the increased inequality within the U.S.
  NOT due to changes in capital income. The rich
  are getting richer because of labor income.
• How do we think about labor income vs. capital
  income for the really rich?
• High salary growth in finance, skilled
  professionals, CEOs, etc. Has nothing to do
  with the increase in capital income.
• Do we only care about the top 1 (or 10)
  relative to the median? What about the gap
  between the 75th percentile and the 25th
  percentile? That has grown dramatically as well
  (college vs. non-college premium).
• What is the optimal policy response if we care
  about inequality? Taxing the rich? Helping to
  educate the poor? Allowing high skilled
  immigration?

57
Outside Piketty Some Final Thoughts

• Are there benefits to income inequality?
• In human capital models, unequal returns to skill
  are necessary to induce people to invest in human
  capital.
• The widening inequality in earnings and the
  buoyant demand for skilled workers also
  indirectly encourages greater growth in the
  economy by increasing the incentives for young
  people to invest in themselves. Gary Becker, The
  Economics of Life

57
58
Outside Piketty Some Final Thoughts

• Is income inequality detrimental to society?
• The economic literature has focused on
  documenting trends in inequality and modeling the
  determinants of income inequality.
• However, the consequences of inequality are
  relatively understudied due to some challenges in
  research design.
• How do we think about
• o The health of societies that are unequal?
• o Intergenerational mobility?
• o Income segregation (do poor and rich people
  choose to live next to each other)?
• o Political participation (who votes? who gives
  money to candidates?)

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