Economics for CED Noémi Giszpenc Spring 2004 Lecture 11: Macro: Government Policy and the Keynesian Model June 21, 2004

Economics for CED

Noémi GiszpencSpring 2004

Lecture 11: Macro: Government Policyand the Keynesian Model

June 21, 2004

Spring 2004 Economics for CED: Lecture 11, Noémi Giszpenc

2

Government Fiscal Policy• “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?

45o

C

C+I

C0ex

pend

itur

e

income/production

Ye

I

C+I+G

G


3

Don’t 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.


4

Bonus: Balanced Budget multiplier

• Suppose government increases G and T by same amount, B. G Ye by B*1/(1-MPC) T Ye by B*MPC/(1-MPC)– Net increase in Ye is

B*(1-MPC)/(1-MPC) = B*1 = 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.

Trygve Haavelmo(b. 1911), 1989Nobel laureate


5

Government deficits & debt

• Deficits mean gov’t 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.


6

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.


7

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

$ Quantity of funds

Investment projects

Investment 1

Investment 2Investment 3

Investment 4

0

Cost of capital 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, people’s 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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Let’s see that graphically

• Based on what we’ve just said, if we graph interest rate on one axis and equilibrium output on the other, we’d expect a bigger Ye for a lower r and a smaller Ye for a higher r.

• Let’s 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?

IS

Ye

r


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Back to the financial markets

• Remember how the Fed sets interest rates? Their method is based on people’s 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

M

rMd

r’

Ms

Md’

Ye went up… soMd went up… but Ms stayed the same, sor went up.


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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.

• Let’s 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 Keynes’s 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.

r

IS

Ye

LM

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 don’t 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.


16

Expectations and surprises

• 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

RGDP

SASshort runaggregatesupply

LASlong run aggregate supply

pric

e le

vel


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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 year’s level of output will resemble last year’s– Thus, a sudden big change in output can cause a change in

people’s 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 what’s 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 there’s 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:

1. Several primary functions close together• Residence, work, entertainment: people outdoors on different

schedules using many facilities in common

2. Short blocks (frequent corners)3. Closely mingled buildings of varying age and condition

• For variation in economic yield they must produce

4. Sufficiently dense concentrations of people

• Capital put to work locally (not completely mobile)• Local currency (responds to local econ. conditions)


25

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 can’t 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:

1. Political (representation, free speech)2. Economic3. Social Opportunities (health, education)4. Political (accountability, transparency)5. 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.

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Economics for CED Noémi Giszpenc Spring 2004 Lecture 11: Macro: Government Policy and the Keynesian Model June 21, 2004