Economics for CED

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Economics for CED

• Noémi GiszpencSpring 2004Lecture 11 Macro
  Government Policyand the Keynesian Model
• June 21, 2004

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Government Fiscal Policy
45o
CIG
expenditure

• Fiscal policy is when national government makes
  decisions on taxation and spending to influence
  the level of production and employment.
• Increasing the autonomous spending, G, increases
  Ye by multiplier.
• If Ye too low, can increase G to combat
  unemployment
• If Ye too high, can decrease G to combat
  inflation
• What about taxes?

CI
C
G
I
C0
Ye
income/production
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Dont forget taxes!

• Consumption depends on disposable income Yd Y -
  T Y - (Yt TX - TR)
• T is net taxes sum of income taxes Yt and
  non-income taxes TX, minus transfers TR
• ? T ? ? Yd ? ? C ? ? Ye
• by a tax multiplier MPC/(1-MPC)
• A cut in taxes and increase of transfers have
  same effect on equilibrium aggregate demand
• But they have different effects in many other
  ways, and are likely to affect different people.
• And have smaller (indirect) effect than changes
  in G.

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Bonus Balanced Budget multiplier
Trygve Haavelmo(b. 1911), 1989 Nobel laureate

• Suppose government increases G and T by same
  amount, B.
• ? G ? ? Ye by B1/(1-MPC)
• ? T ? ? Ye by BMPC/(1-MPC)
• Net increase in Ye is B(1-MPC)/(1-MPC) B1
  B
• balanced budget multiplier is 1
• This means that increasing the size of
  government, all else being equal, increases
  equilibrium output by the exact amount of the
  increase.

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Government deficits debt

• Deficits mean govt must borrow--and pay interest
• The burden of interest payment (debt service)
• Means taxes later to pay interest
• Taxes less wealthy people to pay more wealthy
  people
• If not sustainable, leads to a crisis
• Crowds out private borrowing for investment
  purposes
• Probably only realistic kind of balanced budget
  would be cyclically balanced budget
• government deficits in recession periods offset
  by government surpluses in booms.
• Government spending is also automatically
  anti-cyclical
• progressive income taxes rise with income and
  slow down growth welfare and unemployment
  transfers rise as incomes drop and slow down
  recessions.

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Government Monetary Policy

• Monetary policy is when the national government
  makes changes in central bank policy or in bank
  reserves to influence the interest rate and thus
  investment, production and employment.
• To understand the effects of these changes on the
  macroeconomy, we need to go back to the workings
  of the Federal Reserve system.
• Then we need to relate the movements in money
  supply and interest rate to economic activity.
• It will help to remember the way businesses
  decide to invest.

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A closer look at investment

• In the last class, I was given as exogenous.
• Let us now say that I has an autonomous component
  (I0) and partly depends on the real interest rate
  (r) I I0 I(r)
• (real interest is nominal interest minus
  inflation)
• I(r) goes down when r goes up. Why?
• Remember the figure we drew in class of the
  investments a business chooses based on the
  return from each investment and the cost of
  capital
• If (some) capital is more costly (comes at a
  higher interest rate), some investments will not
  be made.

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Figure from lecture 5 returns costs
Annual costs/returns per 100
Cost of capital funds
Investment 1
Investment 2
Investment 3
Investment 4
Investment projects
0
Quantity of funds
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Effect of r on I (and Y)

• Lenders, too, look for the highest-return
  projects to lend to first.
• These ideas lead to a diminishing marginal
  efficiency of investment (MEI)
• The more is invested, the less return there will
  be on investment
• Investors quit investing when marginal return
  equals marginal cost when MEI r
• If r is low, it takes a while for the MEI to
  diminish down to r
• If r is high, peoples MEI hits r faster.
• Since investment is a component of aggregate
  demand, if I goes up, aggregate demand (Yd) and
  thus equilibrium output (Ye) go up.

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Lets see that graphically

• Based on what weve just said, if we graph
  interest rate on one axis and equilibrium output
  on the other, wed expect a bigger Ye for a lower
  r and a smaller Ye for a higher r.
• Lets call the line IS because it has to do
  with investment and savings.
• Every point on the line is a possible equilibrium
  between interest rate and output.
• Where do we end up?

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Back to the financial markets
Ye went up so ? Md went up but Ms stayed the
same, so ? r went up.

• Remember how the Fed sets interest rates? Their
  method is based on peoples liquidity preference
• A high rate of interest (on, say, bonds) induces
  me to part with some liquidity of money
• A low rate of interest makes me abandon bonds in
  favor of money
• When output rises people demand more money
• because people need money to conduct more
  transactions

r
r
Md
r
Md
M
Ms
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The liquidity-money (LM) equilibria

• With a fixed money supply, an increase in output
  will shift money demand up and result in a higher
  rate of interest at equilibrium.
• Lets graph all of the possible equilibria
  between output and interest rate--this time from
  the financial markets.
• We can call that line of equilibria LM
• As Ye goes up, r goes up

r
LM
Ye
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Put em together and whaddya get?

• A shortcut to understanding much of Keyness
  theory.
• Below the IS curve, low interest rates induce
  more investment ? more Y.
• Above IS, high interest rates inhibit investment
  ? less Y.
• Meanwhile
• Below LM, a high Y (and steady money supply Ms)
  boost interest rates ? higher r
• Above LM, a lower Y reduces demand for money ? r
  falls
• We end up at the intersection.

The IS-LM graph is sometimes called the
Keynesian cross
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Are we nailed to the cross?

• I.e, can the government move the economy away
  from the Ye and r determined by these forces?
• Main method expanding or contracting money
  supply to affect interest rates--basically,
  shifting LM curve
• Control is limited
• Late 70s, Fed tried to limit money, so banks
  created new forms of money (checking accounts)
• Early 90s, Fed created more reserves, but banks
  were afraid to lend, so little new money created
• Analogy using monetary policy to try to
  stimulate economy is like pushing on a string--it
  is easier to slow down economy
• Also, decision to invest depends on more than
  just interest rate
• And indirect effect may take a long time to kick
  in
• Slower (more political) method fiscal
  policy--shifting IS curve by changing G or T
  (once it kicks in, faster effects)
• Needs to be accommodated anyhow by monetary
  policy
• If demand increases but Ms remains constant, only
  change is in r

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The problem of inflation

• Inflation is a rise in the average price level
• Some prices rise faster than average and others
  slower, so inflation redistributes income
  haphazardly
• This uncertainty makes it unpopular
• Inflation hurts creditors (but benefits debtors)
• (And all businesses run on credit)
• What causes inflation?
• Keynesian view 2 kinds of inflation demand pull
  cost push
• If demand for output exceeds capacity of economy
  to produce it, inflation speeds up.
• If costs of production rise, increase is passed
  on to consumers.
• Second more dangerous--price increase can lead to
  further increases in cost, and so to spiraling
  inflation
• Monetarist view changes in the money supply
  dont affect output or the velocity of
  money--only the price level (inflation).
• In the long run, real potential output remains
  unchanged monetary policy can have no effect
  except inflation.

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Expectations and surprises
LAS long run aggregate supply

• When inflation continues over years, people come
  to expect it
• If price rise is a surprise, businesses will
  increase production to reap profit
• This would be in the macroeconomic short run
• If price rise is expected, input costs will rise
  at the same time, leading to unchanged production
• This would be in the macroeconomic long run

p
SAS short runaggregatesupply
price level
RGDP
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The policy ineffectiveness proposition

• Assumption Rational Expectations
• make efficient use of all available information
• Expectations can be rational and still not be
  very accurate.
• Given a population with rational expectations,
• Any consistent government policies designed to
  influence the economy to a level of production
  other than the long-run potential output will be
  ineffective.
• Because people will expect the policies and
  counteract them
• However, output tends to be permanent.
• This years level of output will resemble last
  years
• Thus, a sudden big change in output can cause a
  change in peoples rational expectations--output
  is path dependent

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Now what do we do?

• One reason to study macroeconomics is to try to
  see what is possible and whats not.
• After that, politics is the art of the possible
• The Keynesian model shows that some government
  action is possible.
• But some things are impossible
• For example, every country having a trade surplus
• Watch out for fallacies of composition!
• But have we accounted for all of the effects of
  government action?
• And what important factors have we left out?

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Time lags

• 3 types of lags
• Recognition that there is something to respond to
• Implementation of a policy
• Response by economic actors changes in behavior
• One possible remedy to insufficient data
  triggers (automatic adjustments)
• E.g., tax cuts that only go into effect during
  recession, or only when government can afford them

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Inequality

• In the model, a cut in taxes (TX) has the same
  effect as a rise in transfers (TR)
• But different people are affected
• An increase in government debt means more taxes
  to pay interest
• Generally redistributes money from those with
  less to those who already have lots
• But what effect does unequal wealth or income
  have on the broader economy?

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and its effects

• Trickle-down theorists say inequality is
  good.
• The wealthier you are, the more you save
• Therefore, more money in the hands of rich people
  means more is available for investment, which is
  good for growth, which is good for everybody.
• Assumption increase in rate of saving across few
  people compensates for decrease of saving among
  many people
• Assumption rich people invest domestically
• Assumption investment leads to growth
• Assumption growth is good for everybody
• (A better trick investment tax credits--only
  kick in if investment is made)

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Effect of inequality, continued

• Others say inequality is bad
• In and of itself, but also instrumentally
• To see why we need a broader theory of output, or
  a more detailed one
• Ford? Demand lagging supply?

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Then theres the international problem

• Makes national policy making difficult

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Jane Jacobs recommendations

• Development replaces growth as goal
• Image of tangled bank of interdependent
  processes
• Diversity feeds development of cities
• 4 conditions are necessary for diversity
• Several primary functions close together
• Residence, work, entertainment people outdoors
  on different schedules using many facilities in
  common
• Short blocks (frequent corners)
• Closely mingled buildings of varying age and
  condition
• For variation in economic yield they must produce
• Sufficiently dense concentrations of people
• Capital put to work locally (not completely
  mobile)
• Local currency (responds to local econ.
  conditions)

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Herman Daly recommendations

• Development replaces growth as goal
• optimal scale joins distributive justice, full
  employment, and price level stability as goal
• Hicksian definition of income
• Income is what you can consume now that will
  leave you able to consume same amount next period
• Means cant count consumption of natural capital
  as income
• Tax labor income less, and tax resource
  throughput more
• Bluntly, encourage employment discourage
  throughput
• Maximize productivity of natural capital in the
  short run
• And invest in increasing its supply in the long
  run
• Move away from globalization toward domestic
  (national and local) economies
• Less inequality ? population will control itself

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Amartya Sen recommendations

• Commitment to freedom (as individual capability),
  especially
• Political (representation, free speech)
• Economic
• Social Opportunities (health, education)
• Political (accountability, transparency)
• Security
• Freedoms are not only the primary ends of
  development, they are also among its principal
  means. Development as Freedom, p. 10
• For true development, attention to inequality (of
  freedoms) at the same time as efficiency

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Dollars Sense recommendations

• Productivity growth through worker cooperation
• More job security, portable health benefits,
  minimum wage
• Worker involvement in production
• Moderate inflation OK
• As long as cost-of-living-adjustments are made to
  fixed incomes, or these are automatically indexed
• Shoe-leather costs relatively small
• Provides needed flexibility in wage-setting,
  since it is hard to adjust nominal wages down.