Transcript Lecture 11: Macro: Government Policy

Economics for CED
Noémi Giszpenc
Spring 2004
Lecture 11: Macro: Government Policy
and the Keynesian Model
June 21, 2004
Government Fiscal Policy
– If Ye too low, can increase G
to combat unemployment
– If Ye too high, can decrease
G to combat inflation
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.
G
I
C0
• What about taxes?
Spring 2004
45o
C+I+G
C+I
C
Economics for CED: Lecture 11,
Noémi Giszpenc
Ye
income/
production
2
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
3
Trygve Haavelmo
(b. 1911), 1989
Nobel laureate
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
4
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
5
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
6
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
7
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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
8
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
9
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.
r
– Every point on the line is a
possible equilibrium
between interest rate and
output.
IS
Ye
• Where do we end up?
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
10
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 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
r
r’
r
• When output rises people
demand more money
– because people need money
to conduct more transactions
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
Md’
Md
Ms
M
11
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
Spring 2004
r
Economics for CED: Lecture 11,
Noémi Giszpenc
LM
Ye
12
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.
LM
r
– 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.
Spring 2004
IS
Ye
The “IS-LM” graph is sometimes
called the “Keynesian cross”
Economics for CED: Lecture 11,
Noémi Giszpenc
13
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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
14
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
15
Expectations and surprises
LAS
long run aggregate supply
p
price level
• 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
SAS
short run
aggregate
supply
RGDP
– This would be in the
macroeconomic long run
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
16
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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
17
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?
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
18
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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
19
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?
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
20
…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)
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
21
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?
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
22
Then there’s the international problem
• Makes national policy making difficult
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
23
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
•
2.
3.
Short blocks (frequent corners)
Closely mingled buildings of varying age and condition
•
4.
•
•
Residence, work, entertainment: people outdoors on different
schedules using many facilities in common
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)
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
24
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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
25
Amartya Sen recommendations
•
–
–
Commitment to freedom (as individual capability),
especially:
1. Political (representation, free speech)
2. Economic
3. 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
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
26
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.
Spring 2004
Economics for CED: Lecture 11,
Noémi Giszpenc
27