Transcript Keynsian Economics and Fiscal Policy

Keynesian Economics and Fiscal
Policy
Franklin Roosevelt’s Mandate:

DO SOMETHING!

But what?
Classical Economics wasn’t
working

Two ways to get out of a
depression
Cut taxes
More laissez-faire policies
John Maynard Keynes
1883 – 1946
 Radical idea for
government to spend
money they don’t have
may have saved
capitalism.

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.”
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?”

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.

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.
US Government has not
remembered that final rule of
Keynesian Economics.

When times were good in
the 1990s – taxes were
cut.
Okay, now for the book stuff on
Keynes!
Important Point about Keynes!

Keynsian economics is
SHORT-RUN only.

“In the long run we’re all
dead.”
John Maynard Keynes
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!
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.

Keynesian Cross
ALSO assume:
Consumer / firms
demand for goods is
fixed.
 In the short run output =
demand.

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.

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
Consumption has two parts
Ca = constant and
independent of income.
 Autonomous
Consumption Spending

Things that HAVE to be
purchased, despite
income.
Food
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.

by
B = .6
 Then for every dollar
income goes up,
consumption increases
60 cents.
Y = Both output and income

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.
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)
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.

Changes in the Consumption
Function

Levels of MPC and
autonomous
consumption can change
over time.
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.
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
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.
Changes in the MPC

Autonomous
Consumption is assumed
to be fixed. Increases in
MPC causes function
line to get steeper.
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.
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.

Determining GDP
Equilibrium output is Y
 It occurs where the 45degree diagonal line
crosses C + I.

Represents total
spending for the
economy
Total Spending = Output
Equilibrium in the
economy.
EQUATIONS!

y* = (Ca + I) / (1 – b)
OR
 Equilibrium output =
(autonomous
consumption +
investment divided by 1
– MPC)

Savings and Investment

The Savings Function:
The relationship between
the level of income and
the level of savings.
S=y–C
The Multiplier

FACT: Investment
spending fluctuates.
Recession / Boom
Economy
Interest rates
Etc
The Multiplier

Increase in output
always exceeds the
increase in investment.
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

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.

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

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.

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 $50million increase in GDP
and income.
 Multiplier = 5

The Multiplier Equation

1 / (1-MPC)

Suppose MPC = .8

1/(1 -.8) = 1/.2 = 5
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.

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.
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
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)
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.
Consumption Function for taxes

C = Ca + b (y – T)
Income minus Taxes
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 60cents.
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

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
FIVE situations of recent
Keynesian Policy

Look at page 212
Example: Post 9-11
Government increased
spending for disaster
relief to NYC and
provided loans and
subsidies.
 Tax relief too.

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
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.
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.
Mandatory Spending
Spending levels in these
areas are dictated by the
number of people who
sign up for these benefits,
rather than by Congress
Types of Government Payments
Government Purchases
 Transfer Payments
 Government Interest
Payments

Comparison between the UK and
US Budget Pies
Comparison between UK and US
Fiscal Budgets
US Discretionary Budget Pie
Government Purchases

Sums of money spent for
goods and services for
government.
Xerox machines,
paperclips, office
furniture, commissary
items, guns, tanks,
bombers, etc.
Transfer Payments
Also called Entitlements:
 Outright grants to
people, rather than
something given in
exchange for goods or
services.

Interest Payments
Sums of money paid for
the interest on the
national debt.
 Accumulated from the
debt and deficits.

When a government increases
spending and cuts taxes
DEFICIT!
 More outlays than
receipts of money

More going out than
coming in.
DEBT v. DEFICIT
Deficit = yearly budget
problem
 Debt = YEARS of deficit

Current Debt????
http://www.brillig.com/debt_clock/
OR
Google: “debt clock”
How do we pay for the debt?

US Savings Bonds
IOUs for the government.
Problems with Keynes

He did not think that
government deficit would
be a “big” thing.
IMPORTANT!!!!
Read pages 213 – 216 for examples of
Keynesian Policies in US History!
Automatic Stabilizers

Taxes and transfer
payments that stabilize
GDP without requiring
policymakers to take
explicit actions.
Automatic Stabilizers

When income is high,
government collects
more taxes and pays out
less in transfer
payments.
Does lower GDP and
MPC
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.
Formula for Automatic Stabilizers

T = ty
T = Total taxes taken by
government.
t = tax rate
y = income
Consumer’s after-tax income
will be

(y – ty) = y (1 – t)

See other formulas on p.
217
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.

Most stabilizers are “running
silent”

Depending on the rise or
fall of GDP, tax
collections go up or
down.
No government
intervention is needed.
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.
Marginal Propensity to Import
Imports = M – my
M = imports
m = MPI
y = income
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.
MPI

Slope of the C + I + G +
X is determined by (b –
y)
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.
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

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.
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.
