Transcript ECONOMICS - University of Maryland, College Park

CHAPTER
Chapter 8
The Classical Long-Run Model
Part 2
1
More Important Stuff
• Leakages = T + S
– Income earned by households that they do not
spend on the country’s output during a given
year
• Injections = IP + G
– Spending on a country’s output from sources
other than its households
2
Even More Important Stuff
• At equilibrium, total output (Y) will equal total
spending
Y = C + IP + G
We can do the following:
Y – C = IP + G (move C to LHS)
Y – C – T = IP + G –T (subtract T from each side)
S = IP + G –T(Recall: S = Y-C-T)
S + T = IP + G
• At equilibrium, total leakages are equal to
total injections
S + T = IP + G
3
Leakages and Injections
By definition, total output equals total income.
Leakages: net taxes (T) and saving (S) - reduce consumption spending
below total income.
Injections: government purchases (G) plus planned investment spending (Ip)
- contribute to total spending.
When leakages equal injections, total spending equals total output.
4
Big Question
• What guarantees that leakages are injected
back into the spending stream?
• Answer:
- The loanable funds market where savers
maker their funds available to borrowers
- The supply and demand for loanable
funds.
5
The Loanable Funds Market
• Supply of loanable funds is equal to
household saving
– These funds are loaned out and households
receive interest payments on these funds
• Supply of loanable funds curve (saving)
– shows the level of household saving at
various interest rates
– slopes upward: quantity of funds saved
and supplied to the financial market
increases as the interest rate increases.
6
Household Supply of Loanable Funds
Interest
Rate
Total Supply of Funds
(Saving)
B
5%
3%
A
1.5 1.75
As the interest rate rises,
saving or the quantity of
loanable funds supplied
increases.
Remember: As households
save more they spend less:
As S↑, C↓
S (Trillions of Dollars
per Year)
7
The Loanable Funds Market
• Demand for loanable funds is borrowing
by business firms and the government
• Business demand for loanable funds
– is equal to their planned investment
spending (IP)
– level of investment spending firms plan at
various interest rates
8
Business Demand for Loanable Funds
Interest
Rate
5%
A
B
3%
As the interest rate
falls, business firms
demand more
loanable funds for
investment projects.
Planned Investment (Ip)
(Business Demand for Funds)
1.0
1.5
IP (Trillions of
Dollars per Year)
9
Now the Government
• Government budget deficit, G > T
– Excess of government purchases over net
taxes (G > T).
– In our example, G = $2.0 and T = $1.25.
The deficit = $0.75 trillion.
• Government’s demand for loanable funds
is equal to its budget deficit
– The government must borrow and it pays
interest on funds borrowed
10
The Loanable Funds Market
• Government demand for funds curve:
– Amount of government borrowing at
various interest rates
• We assume this is independent of the
interest rate
• Budget surplus
– Excess of net taxes over government purchases
(T>G)
11
The Loanable Funds Market
• Total demand for loanable funds curve
– Total amount of borrowing at various interest
rates.
– Total demand = [Ip+(G-T)], the sum of desired
business investment plus government deficit.
• As the interest rate decreases
– Total quantity of funds demanded rises
• Quantity of funds demanded by business
firms increases
• Quantity demanded by the government
remains unchanged
12
The Demand for Loanable Funds
Summing business
demand for loanable funds
at each interest rate …
Interest Rate
and the government's
demand for loanable
funds …
Interest Rate
Interest Rate
(b)
(c)
(a)
5%
Business Demand
for Funds (Ip)
B
5%
Government
Demand for
Funds (G-T )
B
3%
1.0
1.5
Trillions of dollars per year
5%
A
A
3%
gives us the economy's total
demand for loanable funds at
each interest rate.
3%
0.75
Trillions of dollars per year
Total Demand for
Funds [Ip+(G-T)]
B
A
1.75 2.25
Trillions of dollars per year
13
Equilibrium in the Loanable Funds Market
• Interest rate will rise or fall until the
quantities of funds supplied and demanded
are equal
• At equilibrium, the market clears.
14
Loanable Funds Market Equilibrium
Interest
Rate
Total Supply
of Funds (Saving)
5%
E
Total Demand for
Funds [Ip+(G-T)]
1.75
Trillions of
Dollars per Year
15
How the Loanable Funds Market Ensures That
Total Spending = Total Output
The leakage of net
taxes (T) goes to the
government and is
spent on
government
purchases (G).
If the government is
running a budget
deficit, it will also
borrow part of the
leakage of
household saving
(S) and spend that
too.
Any household saving left over will be borrowed by business firms
and spent on capital. Thus, every dollar of leakages turns into
spending by either government or private business firms.
16
Say’s law with equations
Loanable funds markets clear 
S
= IP + (G - T)
Quantity of
Quantity of
funds supplied funds demanded
P
Loanable funds markets clear  S + T = I + G
Leakages
Injections
Leakages = Injections  Total spending = Total output
Say’s Law holds as long as the loanable funds market
clears
• Total spending equals total output when all
leakages are injected back into spending
• True even in a more realistic economy
17
Fiscal Policy in the Classical Model:
What happens when things change?
• Fiscal policy is a change in government
purchases or net taxes designed to change
total spending and total output
• Demand-side effects
– Effects on total output that result from
changes in total spending (demand for
G&S)
• Classical model conclusion:
– Fiscal policy has no demand-side effects!
18
Here’ why!
• Increase in G without a change in T:
– the government must borrow the additional funds
– this will increase in the demand for loanable funds
– interest rate increases causing
• Decrease in planned investment spending
• Decrease in consumption spending as households
save more - increase in savings
• The result is the increase in government
purchases crowds out the spending of
households (C) and businesses (Ip)because
the interest rate increases.
19
Example: Crowding Out as a result of a $0.5 Trillion Increase
in Government Purchases from $1.75 to $2.25 Trillion
Interest
Rate
Total Supply
of Funds (Saving)
G↑ = AH = $0.5 trillion
C↓ = AF = $0.3 trillion
IP↓ = FH = $0.2 trillion
B
7%
F
A
5%
C↓
Ip + (G1-T)
1.75
2.05
H
IP↓
Ip + (G2-T)
2.25 Trillions of Dollars per Year
Beginning from equilibrium at point A, an increase in the budget deficit caused by
additional government purchases shifts the demand for funds curve from Ip + (G1 − T) to
Ip + (G2 − T). At point H, the quantity of funds demanded exceeds the quantity supplied,
the interest rate begins to rise. As it rises, households save more, and business firms
invest less. In the new equilibrium at point B, both consumption and investment
spending have been completely crowded out by the increased government spending.
20
Crowding Out
• Crowding out
– the decline in one sector’s spending
– caused by an increase in some other
sector’s spending
• Complete crowding out
– is a dollar-for-dollar decline in one sector’s
spending
– caused by an increase in some other
sector’s spending
• What caused the crowding out????
21
An Increase in G - Bottom Line
In the classical model an increase in
government purchases (G)
• Completely crowds out private sector
spending
• Total spending remains unchanged
• No demand-side effects on total output or
total employment
22
Example: A Decrease in Net Taxes
• Government cuts net taxes (T)
– Why would the gov’t cut taxes?
• To increase total spending.
– Assume: households spend the entire tax cut
– Budget deficit increases as T↓
– Increase in demand for loanable funds
[Ip+(G-T)]
– Interest rate increases causing
• Decrease in planned investment spending
• Decrease in consumption spending as
households save more
23
Crowding Out from a $0.5 Trillion Decrease in Taxes (T)
Interest
Rate
Total Supply
of Funds (Saving)
C↓
B
T ↓ = AH =$0.5 trillion
= Initial C ↑
7%
5%
F
A
Ip + (G-T1)
1.75
2.05
H
IP ↓
Ip + G-T2)
2.25 Trillions of Dollars per Year
Beginning at point A, an increase in the budget deficit caused by a tax cut shifts the demand
for funds curve from Ip + (G − T1) to Ip + (G − T2). If the tax cut is entirely spent,
consumption initially rises by the distance AH. At the original interest rate of 5 percent, the
quantity of funds demanded now exceeds the quantity supplied. This causes the interest
rate to rise. As the interest rate rises, we move from A to B along the supply of funds curve.
Saving rises (and consumption falls) by the distance AF. The final rise in consumption is
FH. We also move along the demand for funds curve from H to B, so investment falls by the
distance FH. In the new equilibrium at point B, consumption (which has risen by FH) has
24
completely crowded out investment (which has dropped by FH).
A Decrease in Net Taxes – Bottom Line
In the classical model, a cut in taxes
• Initially increases consumption
• But the interest rate increases which
crowds out planned investment and
consumption.
• Total spending remains unchanged
• No demand-side effects on total output or
employment
25
The Classical Model and Classical Economist
• Government
– Needn’t worry about employment
• The economy will achieve full employment on
its own.
• Later in the course we will call this the selfcorrecting mechanism
– Needn’t worry about total spending
• The economy will generate just enough
spending on its own to buy the output that a
fully employed labor force produces
• Fiscal policy has no demand-side effects
on output or employment
26