Keynesian Economics and Fiscal Policy

1
Keynesian Economics and Fiscal Policy
2
Franklin Roosevelts Mandate

• DO SOMETHING!
• But what?

3
Classical Economics wasnt working

• Two ways to get out of a depression
• Cut taxes
• More laissez-faire policies

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John Maynard Keynes

• 1883 1946
• Radical idea for government to spend money they
  dont have may have saved capitalism.

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John Maynard Keynes

• The difficulty lies, not in the new ideas, but
  in escaping the old ones, which ramify, for those
  brought up as most of us have been, into every
  corner of our minds.

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John Maynard Keynes

• The avoidance of taxes is the only intellectual
  pursuit that still carries any reward.
• When the facts change, I change my mind. What do
  you do, sir?

7
Keynesian Economics

• Fiscal Policy where it is more important to get
  the people of the country working.
• Government goes into debt to employ people or
  give them benefits until they can find a job.

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Keynesian Economics

• IMPORTANT POINT!!!
• Okay to go into debt when times are bad.
• People are employed, they begin to consume and
  invest again.
• Then government can collect taxes.
• WHEN TIMES ARE GOOD UP THE TAXES TO GET READY
  FOR THE NEXT BAD TIME.

9
US Government has not remembered that final rule
of Keynesian Economics.

• When times were good in the 1990s taxes were
  cut.

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Okay, now for the book stuff on Keynes!
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Important Point about Keynes!

• Keynsian economics is SHORT-RUN only.
• In the long run were all dead.
• John Maynard Keynes

12
Keynes Idea!

• The level of GDP is determined primarily by
  prices.
• Demand driven economy.
• Create demand to improve an economy.
• The New Deal work projects!

13
Keynesian Cross

• 45-degree diagonal represents the relationship
  between demand and output.
• ASSUME that it is a closed economy and Classical
  government.
• C I is all that creates demand.

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Keynesian Cross

• ALSO assume Consumer / firms demand for goods is
  fixed.
• In the short run output demand.

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Equilibrium Output on the Keynesian Cross

• Shows where output equals demand.
• If overproducing, stock piles up, prices drop and
  cutbacks in production.
• If producing at a lower level of outpur, demand
  is greater than their current production.
  Shortages happen.

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The Consumption Function

• In reality, we know that consumer spending
  depends on the level of income in the economy.
• More income More spending
• Consumption Function
• C Ca by

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Consumption has two parts

• Ca constant and independent of income.
• Autonomous Consumption Spending
• Things that HAVE to be purchased, despite income.
• Food

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The second part of consumption by

• The consumption that is dependent on income.
• Marginal Propensity to Consume (MPC) b
• Y income
• MPC tells how much consumption spending increases
  for every dollar that income increases.

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by

• B .6
• Then for every dollar income goes up, consumption
  increases 60 cents.
• Y Both output and income

20
See figure 10.4 on page 204

• Consumption function intersects at Ca , the level
  of autonomous consumption must be greater than
  zero.
• Slope is b, the marginal propensity to consume.
• Output equals income on the x-axis.
• Income rises dollar for dollar with output.

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MPC

• MPC slope is always less than one.
• Consumers who receive a dollar income will spend
  part and save the rest.
• What fraction is saved is determined by MARGINAL
  PROPENSITY TO SAVE (MPS)

22
MPS

• The sum of MPS and MPC MUST equal 1.
• MPC .8
• MPS .2
• So for every additional dollar, consumers spend
  80 cents and saves 20 cents.

23
Changes in the Consumption Function

• Levels of MPC and autonomous consumption can
  change over time.

24
Why would there be an increase in autonomous
consumption?

• Increases in consumer wealth.
• Franco Modigliani proved that increases in stock
  prices, raise consumer wealth and increase
  autonomous consumption.
• Changes in consumer confidence
• Consumer confidence based on household surveys.

25
Current Consumer Confidence Statistics

• The idea behind consumer confidence is that when
  the economy warrants more jobs, increased wages,
  and lower interest rates, it increases our
  confidence and spending power

26
Current Consumer Confidence

• Surveys 5,000 households per month and the want
  ads.
• Currently
• DOWN 67.1 compared to 89.7 in April.
• Figure released May 5
• Lowest since October 2005.

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Changes in the MPC

• Autonomous Consumption is assumed to be fixed.
  Increases in MPC causes function line to get
  steeper.

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Reasons for Changes in the Consumption Function
Slope

• Consumers believe increases in income are
  permanent, and consume at a higher proportion.
• Permanent salary v. one time bonus
• Changes in the TAX RATE.
• What we get back in taxes we SPEND.

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Determining GDP

• Plot the Consumption Function C as a function of
  income
• If we assume that investment is constant at all
  levels we can get the C I line.

30
Determining GDP

• Equilibrium output is Y
• It occurs where the 45-degree diagonal line
  crosses C I.
• Represents total spending for the economy
• Total Spending Output
• Equilibrium in the economy.

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EQUATIONS!

• y (Ca I) / (1 b)
• OR
• Equilibrium output (autonomous consumption
  investment divided by 1 MPC)

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Savings and Investment

• The Savings Function
• The relationship between the level of income and
  the level of savings.
• S y C

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The Multiplier

• FACT Investment spending fluctuates.
• Recession / Boom Economy
• Interest rates
• Etc

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The Multiplier

• Increase in output always exceeds the increase in
  investment.

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The Multiplier

• The ratio of changes in output to changes in
  spending.
• It measures the DEGREE to which changes in
  spending are multiplied into changes in output

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The Multiplier

• Computer firm invests 10-million in building a
  new plant.
• Total spending (y) for economy increases by
  10-million.
• Construction workers and firm are paid.

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The Multiplier

• Suppose the owners of the construction firm and
  their employees buy new cars for 8-million.
• Producers of the cars will expand their
  production because of the increase indicated by
  the demand

38
The Multiplier

• In turn, workers and owners in the car industry
  will earn an additional 8-million in wages and
  profits.
• They will spend part of the income - 6.4 million
  on digital t.v.s and other goods and services.

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The Multiplier

• The rounds continue with diminishing amounts.
• Add up all the spending in all the rounds we find
  the initial 10-million in spending leads to
  50-million increase in GDP and income.
• Multiplier 5

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The Multiplier Equation

• 1 / (1-MPC)
• Suppose MPC .8
• 1/(1 -.8) 1/.2 5

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The Multiplier

• It can also work in reverse!
• Consumers cut back on autnomous consumption by
  10-million.
• GDP falls by 10-million, output and income fall.
• Ending in 50-million loss.

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The Multiplier

• The multiplier increases as the MPC increases
• Multiplier occurs because initial increase in
  investment spending increases income which leads
  to higher consumer spending.
• Higher MPC increase in consumer spending
  increases.

43
Keynesian Fiscal Policy

• The use of taxes and government spending to
  affect the level of GDP in the short-run.
• Influences on demand for goods and services

44
Government makes purchases in the economy too!

• C I G total spending including government.
• Increases in G purchases shift the C I G line
  upward.
• Multiplier effect the same for government
  spending
• 1 / (1 MPC)

45
What role do TAXES play?

• Disposable Personal Income The income that
  flows back to households, taking into account
  transfers and taxes.
• AFTER subtraction from income of any taxes paid
  and the addition of any transfer payments.
• Social Security, welfare, unemployment, etc.

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Consumption Function for taxes

• C Ca b (y T)
• Income minus Taxes

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Consumption Function for taxes

• If taxes increase by 1, after tax income will
  decrease by 1.
• Since MPC is b it means that consumption will
  fall by b x 1.
• b .6 and a 1 increase in taxes means
  consumers have a dollar less in income and will
  decrease consumption spending by 60-cents.

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The Tax Multiplier is NEGATIVE

• Increases in taxes decreases disposable personal
  income and lead to a reduction of consumption
  spending.
• If MPC is .6
• Tax multiplier will be -.6 / (1 - .6) - 1.5

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What do you think happens when we increase govt.
spending and taxes at the same time???

• EQUAL increases in taxes and government spending
  will INCREASE GDP

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FIVE situations of recent Keynesian Policy

• Look at page 212

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Example Post 9-11

• Government increased spending for disaster relief
  to NYC and provided loans and subsidies.
• Tax relief too.

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Two Terms for Fiscal Policy

• Expansionary Policies
• Government policy actions that lead to increases
  in output
• Contractionary Policies
• Actions that government does that leads to a
  decrease in output

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Two Types of Government Spending

• Discretionary spending, which accounts for
  roughly one-third of all Federal spending,
• includes money for things like the Army, FBI, the
  Coast Guard, and highway projects.
• Congress explicitly determines how much to spend
  (or not spend) on these programs on an annual
  basis.

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Two Types of Government Spending

• Mandatory spending accounts for two-thirds of all
  government spending.
• This kind of spending is authorized by permanent
  laws. It includes "entitlements" like Social
  Security, Medicare, and Food Stamps
• programs through which individuals receive
  benefits based on their age, income, or other
  criteria.

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Mandatory Spending

• Spending levels in these areas are dictated by
  the number of people who sign up for these
  benefits, rather than by Congress

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Types of Government Payments

• Government Purchases
• Transfer Payments
• Government Interest Payments

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Comparison between the UK and US Budget Pies
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Comparison between UK and US Fiscal Budgets
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US Discretionary Budget Pie
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Government Purchases

• Sums of money spent for goods and services for
  government.
• Xerox machines, paperclips, office furniture,
  commissary items, guns, tanks, bombers, etc.

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Transfer Payments

• Also called Entitlements
• Outright grants to people, rather than something
  given in exchange for goods or services.

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Interest Payments

• Sums of money paid for the interest on the
  national debt.
• Accumulated from the debt and deficits.

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When a government increases spending and cuts
taxes

• DEFICIT!
• More outlays than receipts of money
• More going out than coming in.

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DEBT v. DEFICIT

• Deficit yearly budget problem
• Debt YEARS of deficit

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Current Debt????

• http//www.brillig.com/debt_clock/
• OR
• Google debt clock

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How do we pay for the debt?

• US Savings Bonds
• IOUs for the government.

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Problems with Keynes

• He did not think that government deficit would be
  a big thing.

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IMPORTANT!!!!

• Read pages 213 216 for examples of Keynesian
  Policies in US History!

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Automatic Stabilizers

• Taxes and transfer payments that stabilize GDP
  without requiring policymakers to take explicit
  actions.

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Automatic Stabilizers

• When income is high, government collects more
  taxes and pays out less in transfer payments.
• Does lower GDP and MPC

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Automatic Stabilizers

• But in recessions the government collects less
  taxes and pays out more in transfer payments.
• Increases consumer spending.
• Money is in the hands of the consumers.

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Formula for Automatic Stabilizers

• T ty
• T Total taxes taken by government.
• t tax rate
• y income

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Consumers after-tax income will be

• (y ty) y (1 t)
• See other formulas on p. 217

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Increases in the Tax Rate

• Decreases the slope of C I G.
• Lowers output and reduces the multiplier.
• Smaller multiplier means smaller shocks to
  investment and have less impact on the economy.

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Most stabilizers are running silent

• Depending on the rise or fall of GDP, tax
  collections go up or down.
• No government intervention is needed.

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FINALLY!!!! Exports and Imports in a Keynesian
Model

• Exports and imports influence how the world
  beyond the US demands goods and services produced
  in the US.

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Marginal Propensity to Import

• Imports M my
• M imports
• m MPI
• y income

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MPI Marginal Propensity to Import

• The fraction of additional income that is spent
  on imports.
• b m.
• b .8
• m .2
• (.8 - .2) .6 is now the MPC adjusted for
  imports.

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MPI

• Slope of the C I G X is determined by (b
  y)

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Just Suppose

• The Japanese decide to by another 5-billion
  worth of goods from the US.
• What happens to US domestic output?
• Demand line shifts vertically upward with the
  increase in exports.
• Income increases.

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Therefore

• .6 is the multiplier
• 1 / (1 - .6) 2.5
• Therefore a 5-billion increase in exports will
  lead to a 12.5 billion increase in GDP

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But!

• US citizens are more attracted to foreign goods,
  and as a result, our marginal propensity to
  import increases.
• The MPC(b-m) will fall as the marginal propensity
  to import increases.
• Reduces the slope of the demand line and output
  will fall back.

83
The Netherlands Multiplier

• The multiplier differs from country to country.
• US has a bigger multiplier for government
  spending than the Netherlands.
• Reason? Smaller country that imports more than
  the US does.